What Should the Grand Bargain Look Like?

It’s 2010.  That means WWII ended 65 years ago.  And that means a fiscal train wreck is approaching fast.  And that means it’s time for one of those committees of “wise men” to reach some sort of grand bargain, which provides political cover for both sides.

WASHINGTON (AP) — President Barack Obama Saturday endorsed a bipartisan plan to name a special task force charged with coming up with a plan to curb the spiraling budget deficit, though the idea has lots of opposition from both his allies and rivals on Capitol Hill.

The bipartisan 18-member panel backed by Obama would study the issue for much of the year and, if 14 members agree, report a deficit reduction blueprint after the November elections that would be voted on before the new Congress convenes next year. The 14 would have to include at least half of the panel’s Republicans — a big obstacle.

“These deficits did not happen overnight, and they won’t be solved overnight,” Obama said in a statement. “The only way to solve our long-term fiscal challenge is to solve it together — Democrats and Republicans.”

The deficit spiked to an extraordinary $1.4 trillion last year and could top that figure this year as the struggling economy puts a big dent in tax revenues. Even worse from the perspective of economists and deficit hawks, the medium-term deficit picture is for deficits hitting around $1 trillion a year for the foreseeable future.

Before I begin, I’d like to clarify a few points.  I am not going to discuss my preferred solution, which is the Singapore small government model.  Rather, I will consider a solution that might actually be politically feasible given the realities of American politics, although even I’d admit it would be a stretch.  And finally, I will use numbers that I think are plausible, but the actual numbers would be somewhat different, as I am not a walking computer.

The basic problem is that the current trajectory of spending and taxes is not sustainable.  For most of my life federal spending has been around 21% of GDP and federal taxes have been around 19%.  The 2% of GDP budget deficit has been sustainable, indeed the debt/GDP ratio in 2008 wasn’t much different than the year I was born (1955.)  But we no longer are on a sustainable path.

For simplicity, assume spending is likely to move to a 26% of GDP plateau; that means we then need another 5% of GDP from taxes.  Experts on the European model such as Peter Lindert say that they are able to support large governments only by having relatively efficient tax systems, which rely more heavily on regressive taxes like the VAT, the payroll tax, and the gas tax.  The progressivity of their system comes from bigger government benefits programs for the unemployed, health care, child care, etc.  This is pretty much common knowledge among the smarter public finance economists on both the left and the right.

As of today, President Obama is not in a strong negotiating position.  I think he understands that the government needs more money if the Democrats’ goals are to be achieved, but also knows that Congressional Democrats would not be enthused about implementing a 12% VAT and higher gas taxes on a party line vote.  And I can’t blame them.  The Republicans have three choices.

1. Put “moderates” on the commission who will cave into the Democrats’ demand for a VAT, in return for token Republican objectives.
2. Stonewall, letting Obama stew in his own juices until they can re-take power.
3. Do the sort of grand compromise I will describe below.

I think Republicans would be foolish to choose the first option, but that hasn’t always stopped them in the past.  The most likely scenario is the second, but that isn’t necessarily in their interest either.  When they retake power they are going to be faced with the same difficult decisions, and the Democrats would (quite rightly) be reluctant to bail out a Republican Party that had just refused to cooperate with them.  So what sort of grand bargain would be fair to both sides?  The answer starts from the insight that the public policy world is full of “free lunches,” or changes in public policy that produce massive net gains for society.  I will try to describe one such policy package:

1.  Raise about 7% of GDP through a VAT (and gas or carbon tax if you wish; those details aren’t important here.)  Now you have an extra 2% of GDP to work with.

2.  Abolish the income tax.  I seem to recall that the income tax raises about 8% or 9% of GDP.  So to get the extra 5% percent of GDP you would need another tax to raise about 6% or 7& of GDP in other taxes.

3.  The other tax would also have to be very progressive, or else the Dems will never go along.

4.  Increase the payroll tax on upper-middle class and wealthy American enough to raise at least 6% of GDP.  Currently the tax has a flat rate of about 15.3%, and then drops to about 2.5% somewhere over $100,000 a year.  Under my plan those making over $100,000 would face a marginal payroll tax more in the 25% to 40% range, although I have no idea what the exact numbers would be.  There would probably be a graduated system, with perhaps a 20% rate for those making between $60,000 and $100,000.   The EITC might have to be increased a bit to offset the VAT, and ditto for low income Social Security recipients.   The experts would tweak the rates so that the overall progressivity of the tax system (including the VAT) is roughly unchanged.  I think that would be necessary to getting any deal.

5.  Then we need to follow Steve Forbes’ advice and abolish the income tax entirely.  If we try to simply reform it (as in 1986) the bracket creep and loopholes will gradually return over time.  If we abolished it entirely that would represent a pretty definitive repudiation of the whole idea.  The Senate would likely filibuster any future attempt to reinstate it.

6.  That would be enough, as even liberal economists understand that a progressive consumption (or payroll) tax is better than an income tax (which double-taxes saving.)  But it would still look unfair to the average person as the rich coupon clippers wouldn’t seem to be paying much tax at all (although they actually would be paying taxes indirectly).  So you change the system so that taxation of capital is done at the source.  Banks would withhold taxes on interest, bond issuers on bonds, corporations would withhold taxes on dividends before they are paid out.  This means taxes on capital could not be progressive, but that’s not much of a problem as the poor receive very little capital income.  Any distributional effects could be offset by tweaking the payroll and EITC rates.  We could also allow corporations to expense new investment, which I believe would greatly reduce the problem of “double taxation of saving.”  I’ll leave the complex issue of taxing capital to the experts.

What are the advantages of this deal?

1. Republicans get rid of the hated income tax.
2. Democrats get political cover to expand the federal government as a share of GDP through higher taxes.
3. Neither side wins or losses through changes in progressivity.
4. Most importantly, you get massive net efficiency gains over the more likely alternative.

And what is the more likely alternative?  A mushy compromise.  Government only grows by 3% of GDP, not 5%.  The other 2% is cut through means-testing entitlements and other changes.  The income tax stays in place, massively distorting health care, housing, and all sort of other sectors.  In addition, using up valuable labor to deal with the complexity of the system.  Also remember that means-testing is really just another implicit marginal tax rate, so no Republican that worries about high MTRs should go for a plan that slightly reduces the growth in explicit taxes, if the means-testing raises IMTRs.  And means-testing means even more complexity, more forms to fill out.

By now you must think I am a John Lennon-type dreamer.  Yes, but I’m not the only one . . .

Seriously, it is a long shot, but maybe a bit less far-fetched that it seems.  There is currently near-total gridlock in government.  Any deal at all would be extremely difficult to achieve.  But at some point there simply must be some sort of deal.  And don’t talk about inflation as a solution, a bit more inflation would help a lot right now, but it doesn’t address the long run steady-state issues.  You can choose to be as cynical as you want, but we aren’t going to have 50% steady-state inflation in this country.  It will be higher taxes and/or lower spending.  Given that my proposal has such large net efficiency gains as compared to the more likely alternative, it’s not impossible that such a compromise might emerge from a committee of statesmen (and women.)  Whether it can get through Congress is another thing.  But sometimes you need to be so bold that the special interest groups just get overwhelmed, or form a circular firing squad.  The cut in the top rate from 70% to 28% under Reagan did hurt some special interest groups, but it also got substantial support from both liberals and conservatives in Congress.

In the end what makes me slightly optimistic about this solution is the incredible difficulties of achieving any other solution, combined with the fact that some sort of deal will almost certainly need to occur within the next 10 years.  The alternative muddled compromise that I described earlier could also be constructed in such a way as to appear to leave the balance of power relatively unchanged.  But in practice, any gains to the Republicans would be ephemeral, as their preferred reforms would be washed away over time, while the VAT would hang around forever.  That might seem to imply that the alternative approach is better for the Democrats.  But I don’t see it that way, as public finance isn’t a zero sum game.  In a two party system the two parties will always take turn governing, that is a given.  The real question is: What sort of policy outcomes do we get?  And that is far from being a zero-sum game.

PS.  I would allow states to piggy-back onto this system if they wished, so that they could also raise taxes more efficiently.  This would allow states to abolish their income and sales taxes, and replace them with VATs and progressive payroll taxes.  Also, if you are comparing the 26% of GDP to European numbers, don’t.  You need to add in state and local spending.  If the US federal government moved up to 26% of GDP, then total government spending would move up to the bottom end of the Western European level, and above Australia/Canada/Japan, unless I am mistaken.  Given the anti-tax character of Americans, I don’t think the Democrats could realistically expect anything higher.