America's Fiscal Future Hinges on Tax Reform
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By Lawrence Summers,
February 27, 2012

However the U.S. presidential election turns out, the trifecta of the Bush tax cut expiration, the debt limit ceiling on the horizon once again, and the congressionally mandated sequesters - cuts in domestic spending - will force the president and Congress to wrestle with fiscal issues, either in a lame-duck session after the election or in early 2013. The decisions they make will have profound impacts on America's fiscal future.

For many observers, the central question on the table is about entitlement programs: What will be done with them? Growth in entitlement spending associated with our aging population and its rising healthcare costs is the major factor in overall federal spending growth. But the capacity of near-term policy changes to have large impacts on that spending is less than many would suppose. The rising ratio of retirees to workers means that Social Security benefits at current levels will not be sustainable without some kind of tax increase. Sooner or later, revenue will have to rise or else outlays will have to be curtailed. While it is surely better to act sooner, the reality is that, out of necessity, action on entitlements is inevitable.

While almost everyone agrees on the desirability of containing federal healthcare spending, this is likely to be more difficult than we'd like to believe. Certainly, beneficiaries can bear more of the cost of their government insurance than others, and there are steps like malpractice reform and the further encouragement of preventive medicine that should be taken. Yet without intrusions into the private healthcare system that are unlikely to be politically acceptable, there are severe limits on what can be done.

Otherwise, the result will be unacceptable cuts in the availability of care for the clients of federal programs. Given all the uncertainties associated with new technologies, changing lifestyles, and ongoing changes in the private system, healthcare reform will and should be a continuing project.

But let's place healthcare aside for now. Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the United States will need to mobilize more revenue. This year, the federal government will collect less than 16 percent of GDP in taxes - far below the post-World War Two average. The combination of an aging society, rising health care costs, debt service costs that will skyrocket whenever interest rates normalize, a still-dangerous world in which our allies' defense spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that in all likelihood federal spending will need to be larger, not smaller, relative to GDP in the future.

Raising marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious issues about incentive effects or encouraging tax-shelter activities. Raising rates is, in any event, unlikely to be politically feasible. A much better strategy for raising necessary revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission that tax expenditures are a form of government expenditure and presumptively should be cut back unless they can be justified.