April 27 (Bloomberg) -- Congress will return from its spring recess next week to debate just how large a tax burden Americans can and should shoulder, an issue at the core of the discussion about reducing the U.S. budget deficit.
Many Republicans, determined to prevent tax increases, say federal revenues shouldn’t exceed 18 or 19 percent of gross domestic product, the nation’s total output. Senate Republicans have offered a constitutional amendment that would cap the federal take below 17 percent of GDP. President Barack Obama, meanwhile, has proposed a budget that would push revenue to 20 percent of GDP by the end of the decade and announced a proposal April 13 that would raise that number even higher.
In an economy projected to reach about $24 trillion by the end of the decade, each percentage point represents $240 billion. That means Obama and some Republicans in Congress are more than $700 billion a year apart. The gap represents divergent visions of the size, scope and role of government.
“I think the center of this country is that they don’t want any tax increases,” Representative Tom Price of Georgia, chairman of the House Republican Policy Committee, told reporters April 12. “They recognize that the government spends too much and it is time to get government spending under control.”
The debate over the size of the federal tax burden comes as it stands at a 60-year low of 14.8 percent of GDP, because of the recent recession and tax cuts. The economic recovery will push that ratio up, even if Congress does nothing, as incomes and profits increase over the next few years. Just how high it will go and should go is the issue being discussed.
Congressional Republicans emphasize that the revenue-to-GDP ratio is an attempt to focus the debate on taxes rather than on the fate of popular programs under a hard cap on the size of government, said Leonard Burman, a professor of public affairs at Syracuse University in Syracuse, New York.
“It does hide how difficult the budget challenge is,” he said. “If you’re talking about keeping revenues at 18 or 19 percent of GDP, you’re talking about enormous cuts in public services for years to come.”
Since World War II, the federal tax take has averaged between 18 and 19 percent of GDP, and that has become the upper limit that Republicans such as Representative Paul Ryan, chairman of the House Budget Committee, do not want to breach. A constitutional amendment to balance the budget backed by Utah Senator Mike Lee, a Republican, pegs the 18 percent target to the prior year’s economy, setting an effective cap of 16.7 percent.
The reluctance of these Republicans to raise taxes separates them from Obama, two bipartisan panels and a bipartisan group of six senators, who maintain that tax increases should be part of a deficit reduction package.
Rising Health Costs
Budget analysts across the political spectrum say it is unrealistic to hold revenue to historic levels because rising health care costs will place extraordinary demands on Medicare.
“You don’t create the future by looking at the past, OK?” said David Walker, the former U.S. comptroller general, who is founder and chief executive of the Comeback America Initiative, a nonprofit group that advocates deficit reduction. “You need to learn from history, but you also need to look at the trends and the forces that will drive the future.”
Walker says tax increases should make up about one-quarter of a federal deficit-reduction effort that should focus more on debt-to-GDP ratios than on revenue or spending levels.
Sticking with historic averages of taxation at about 18 percent of GDP and spending at about 20 percent would require curbing future benefits and would avoid shrinking the private sector, said Keith Hennessey, director of the National Economic Council under President George W. Bush. As the economy grows, annual budget deficits averaging about 2 percent of GDP would cause the debt-to-GDP ratio to drop.
“If you don’t mind having a much smaller private sector, then you can continue the programs the way they’ve been operating,” he said. “But that is fundamentally different than, I think, most people’s vision of America.”
Federal Tax Revenue
Since the creation of Social Security and the military expansion that accompanied World War II and the Cold War, federal tax revenues have fluctuated around 18 percent of the economy, according to the Office of Management and Budget. The low point of 14.4 percent came in 1950, and the high of 20.6 percent occurred in 2000.
Economists generally agree that higher taxes restrain economic growth, though other factors make it hard to isolate that effect and determine how the economy would have fared under a different tax structure. For instance, the economy performed well during the 1990s after tax increases, and job growth was relatively slow during the 2000s after tax cuts.
Tax revenue plummeted in 2009 to 14.9 percent, again because of a recession and tax cuts. They remained at that level in 2010 and are projected to be about the same this year.
According to the Congressional Budget Office, tax revenue will average 19.9 percent over the next decade, reaching 20.8 percent in 2021, if Congress doesn’t act. That’s in part because of the scheduled expiration of income tax cuts at the end of 2012. Extending those tax cuts would yield revenue averaging about 18 percent for the decade, according to CBO.
‘Pockets of Taxpayers’
Republicans who favor holding revenue at postwar levels make several points. One is the past-is-prologue argument, the contention that the government and the economy functioned well enough during the postwar period.
“I abide by the principle that 18 percent of the GDP of this country is good enough for the government to spend,” Senator Charles Grassley, an Iowa Republican, said in an April 13 floor speech. “That leaves 82 percent in the pockets of the taxpayers for them to decide how to spend, because if 535 of us decide how to divide up the resources of this country, it doesn’t do as much economic good.”
The period from World War II through today is fundamentally different from the coming period, because of the retirement of the baby boom generation and the continuing rise of health care costs at a rate faster than the economy, Burman said.
Without changes, Medicare and Social Security will cost about 9.3 percent of GDP by 2020 and 12.1 percent by 2035, compared with 8.4 percent today, according to CBO.
Holding revenue to a percentage of GDP “completely ignores the demographic changes,” Burman said.
Focus on Spending Cuts
Republicans such as House Majority Leader Eric Cantor and Senator Orrin Hatch say spending cuts should be the sole path to deficit reduction.
“Washington does not have a revenue problem,” Cantor said on Fox News April 14. “It’s got a spending problem.”
A spending-only approach, as outlined in the budget authored by Ryan and passed by the House this month, would require major changes to Medicare and Medicaid that would leave future beneficiaries with less generous health care, said Alan Viard, resident scholar at the American Enterprise Institute, a Washington policy center that favors smaller government.
“It requires changing these commitments in a way that I think is not going to happen politically,” Viard said.
Some Republicans also rely on an argument dubbed Hauser’s Law, named for W. Kurt Hauser, a former chairman of the Hoover Institution in California. He contended that the relative stability of the revenue-to-GDP ratio occurs because taxpayers react to higher taxes by underreporting income and shunning productive investments for tax shelters.
“That’s where we’ve been historically, and that tends to be what our tax code raises,” said Curtis Dubay, senior policy analyst at the Heritage Foundation, a Washington policy group that favors smaller government.
Hennessey, Burman and Viard said the consistency of revenues near 18 percent is more political than economic. When tax rates rise, the U.S. elects lawmakers who cut taxes, as when Ronald Reagan took office in 1981 and Bush did in 2001.
Viard said any increase in tax collections should be accompanied by changes to the tax system to minimize economic harm.
“If we’re able to survive raising 19 percent of revenue from a badly flawed tax system,” he said, “there cannot be any disaster from raising 20 or 21 percent from a better tax system.”
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