The Perils of Pay Less, Get More
By David Leonhardt, nytimes.com, March 16, 2010
As a society gets richer, its tax rates tend to rise.
This idea is known as Wagner’s Law, named for the 19th-century economist who came up with it. Citizens of richer societies generally prefer more government services, Adolf Wagner explained. With their basic needs met, they want a military to protect them, good schools for their children, comfortable retirement for the elderly, medical care even when it isn’t profitable and a strong social safety net.
Sure enough, the United States followed this path for most of the last century. In 1900, federal taxes amounted to just 2 percent of gross domestic product. By 2000, the share had risen to 21 percent.
Over the last couple of decades, though, we have repealed Wagner’s Law — or, more to the point, only partly repealed it. Taxes are no longer rising. They fell to 18 percent of G.D.P. in 2008 and, because of the recession, to a 60-year low of 15.1 percent last year.
Yet our desire for government services just keeps growing. We added a prescription drug benefit to Medicare. Farm subsidies are sacrosanct. Social Security is the third rail of politics.
This disconnect is, far and away, the main reason for our huge budget problems. Yes, the wars in Iraq and Afghanistan, the recession and the stimulus have all added to the deficit. But they are minor issues in the long run. By 2020, government spending is projected to equal 26 percent (and rising) of G.D.P., mostly because of Medicare and Social Security. Taxes are on pace to equal just 19 percent.
On Friday, Congressional Republicans named six members of a deficit commission that President Obama created last month. In all, the commission will have 10 Democratic members and eight Republicans. It is scheduled to issue its recommendations late this year.
“By any reasonable projection, we’re on an utterly unsustainable path,” Peter Orszag, the White House budget director, told me last week. “And the fiscal commission, while not guaranteed to succeed, offers the best hope of getting ahead of this problem before it becomes a true crisis.”
The commission can succeed, of course, only if it comes up with solutions that Congress and the White House accept. For now, political leaders in both parties are still in denial about what the solution will entail. To be fair, so is much of the public.
What needs to happen? Spending will need to be cut, and taxes will need to rise. They won’t need to rise just on households making more than $250,000, as Mr. Obama has suggested. They will probably need to rise on your household, however much you make.
A solution that relied only on spending cuts would dismantle some bedrock parts of modern American society. Paul Ryan, the ranking Republican on the House Budget Committee, recently released such a plan, and it got rid of Medicare for everyone now under 55.
A solution that relied only on taxes would muzzle economic growth. To cover the costs of future spending — the retirement of the baby boomers and everything else — federal taxes would have to rise by almost 50 percent, immediately and permanently, according to a recent analysis by the economists Alan Auerbach and William Gale.
A solution that combined spending cuts and tax increases would not need to be ruinous — or start in the next couple of years, when unemployment is likely to remain high. But the federal government does have a decent amount of fat in it. And, just as Wagner pointed out, tax increases are not inherently bad. Done right, they do not even have to reduce economic growth by much.
In recent years, economic research has suggested that moderate changes in the tax law don’t actually have a huge impact on growth. You don’t need econometrics to grasp this, either. Just look at the last 20 years. Economic growth after Bill Clinton’s tax increases was far more rapid than economic growth after George W. Bush’s tax cuts. Despite the Bush tax cuts, average annual growth over the last decade — even before the Great Recession began — was slower than in any decade since World War II.
The biggest hurdle to solving the deficit problem will be politics, not economics. Even if the tax increases and spending cuts don’t need to be ruinous, they will not be popular. None of us like the idea of losing benefits or paying more taxes. That’s why Mr. Obama and Congress have outsourced the first stage of the process to a commission.
On the spending side, health care is easily the biggest item. Not only will many people in their 50s and 60s live into their 80s, but technological advances will make medical care for any individual person much more expensive in the future.
A crucial aspect of the final health reform bills is that they take early steps toward trying to distinguish between care that makes people healthier and care that does not. These steps, along with some Medicare cuts, are the reason that many economists think the bills will reduce the deficit. The bills will also make it easier for Medicare to make further changes in the future.
Beyond heath care, Social Security benefits could be reduced for high-income households, and the annual inflation adjustment could be trimmed (making it more accurate, some economists believe). Many corporate subsidies — for agribusinesses and banks, among others — serve no useful economic function. Some military contractors could also stand to be squeezed.
Don’t expect that any one program can close the deficit, though. Military spending, for example, already takes up a much smaller share of the budget than a few decades ago, as Douglas Elmendorf, the head of the Congressional Budget Office, said last week. Without the end of the cold war, the deficit might have already soared.
On taxes, the affluent can certainly stand to pay higher rates than they have. Over the last three decades, they have received both the biggest pretax pay increases and the biggest tax cuts. But there is not enough money at the top to eliminate the long-term fiscal gap. Households making more than $250,000 pay federal taxes equal to only about 5 percent of G.D.P.
The ideal way to raise taxes for everyone else is not through the income tax code — which can affect people’s incentive to work — but through another means. As Victoria Perry of the International Monetary Fund points out, every industrialized country in the world except Saudi Arabia and the United States has some kind of consumption tax. A modest consumption tax would give households more incentive to save and could raise significant revenue. Another option is to reduce some big deductions, like the one for mortgage interest.
I’ll confess that I have a hard time seeing how any of this will happen in the next few years, no matter what the deficit commission recommends. Congressional Republicans have shown little willingness to consider any tax increases, and Mr. Obama has shown no indication of breaking his $250,000-and-under pledge. We voters, meanwhile, tend to oppose government spending in general while supporting the government programs that the spending pays for.
But a lot can happen in a few years. For one thing, interest rates on government bonds are likely to rise, making the need to reduce the deficit more pressing. “It doesn’t seem like policy makers are currently afraid of the bond market,” Mr. Orszag says, “and I wish that weren’t the case.” Someday soon, they may have to be.
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