Saturday, April 10, 2010

The Coming US Fiscal Wreck

Everybody likes to talk about sustainability these days, so maybe they should be focusing on the main, real, and certain sustainability problem of most nations: their rotten fiscal realities, in particular, the easily predictable coming US fiscal wreck. Here is Williams and Altshuler on the topic (HT Mankiw):

Washington spends more than it takes in through tax revenues, resulting in a projected budget deficit of almost $1.35 trillion in 2010, or 9 percent of GDP, according to the Congressional Budget Office. Couldn't we get rid of the deficit by raising taxes?

No. A study we conducted at the Tax Policy Center found that Washington would have to raise taxes by almost 40 percent to reduce -- not eliminate, just reduce -- the deficit to 3 percent of our GDP, the 2015 goal the Obama administration set in its 2011 budget. That tax boost would mean the lowest income tax rate would jump from 10 to nearly 14 percent, and the top rate from 35 to 48 percent.

What if we raised taxes only on families with couples making more than $250,000 a year and on individuals making more than $200,000? The top two income tax rates would have to more than double, with the top rate hitting almost 77 percent, to get the deficit down to 3 percent of GDP. Such dramatic tax increases are politically untenable and still wouldn't come close to eliminating the deficit.


Brad said...

Do these numbers also take into account the expected fall in incomes if the tax rates were raised that high? Because I have seen studies that say that the optimal taxation rate is around 40%, and beyond that revenues will fall with increased taxation.


Pedro H. Albuquerque said...

Hi Brad, their estimates are "optimistic," meaning, they assume no behavioral response. They explain it in this passage:
"Our estimates ignore any behavioral response by taxpayers to higher rates. A long line of
research, starting with Feldstein (1999), has shown that tax increases lead individuals—
particularly those at the top of the income distribution—to decrease their taxable income either
by cutting back on hours worked, by shifting income from taxable to non-taxable form, or by
spending more on tax-deductible items. While analysts disagree on the magnitude of the taxable
income elasticity, there is consensus that high-income taxpayers—precisely the ones that we
target in most of our reforms—are more sensitive than other taxpayers to increases in marginal
tax rates.10 Given the size of the tax increases we consider, behavioral responses would
undoubtedly lead to substantial reductions in taxable income. Given that behavioral response,
reaching either of our deficit reduction goals would require even higher tax rates and might even
prove to be impossible."
It means that the wreck may perfectly be even worse, although to be fair estimates could also sometimes underestimate things such as future economic growth.