Deficits

A RESPONSE: Deficit reduction should include tax reform

Posted on Thursday, February 17, 2011

THE US fiscal position has deteriorated significantly over the past few years. Fiscal policymakers have so far opted to postpone fiscal consolidation with a view to getting the economy back on a firmer footing.
But the US is walking a fine line. The costs of delaying consolidation in terms of risks to credibility, long-term interest rates and economic growth in the medium and long run must also be considered. Waiting to put fiscal policy on a sustainable course pumps government debt up further. Without doubt, rapid debt accumulation increases the likelihood of a fiscal crisis, with investor confidence in the government’s ability to handle its budget undermined and borrowing rates pushed up to unaffordable levels.
Pinpointing a debt-to-GDP ratio which indicates that a crisis is likely or imminent is difficult. Many factors appear to be important in triggering a crisis, including the long-term budget outlook and whether the economy is growing or appears to be in weak state. Presently, economic indicators suggest that the US economy gathered pace over the second half of 2010 and into this year and will be strong enough to produce visible positive effects on employment. Solid growth should alleviate investors’ concerns.
Nevertheless, the US fiscal problems are not just cyclical but also structural, rendering sweeping fiscal consolidation inevitable. Republican members of Congress are already demanding fiscal reforms in the current fiscal year. The desired measures appear to include a whopping $100 billion cut in discretionary spending levels as a first step to return budget appropriations to FY 2008 levels.
Given the current political situation the Obama administration will likely pick up on some proposals although such a compromise would undermine the aim of the Tax Relief, Unemployment Insurance Reauthorisation, and Job Creation Act of 2010.
Meaningful fiscal reform requires long-term measures to rein in the deficit. Regaining fiscal flexibility and preparing for the long-run budgetary challenges associated with the ageing of the population requires a downward path of the debt-to-GDP ratio in the second half of this decade. To achieve this, spending cuts are unlikely to suffice, so higher tax revenues by way of a better-designed tax system must be part of the solution.
Indeed, the latitude available for increasing tax revenues would seem to be greater in the US than elsewhere, as the tax-to-GDP ratio is among the lowest in the OECD area. In order to limit the negative impact on economic incentives, broadening the tax base should clearly be considered. Tax exemptions are more generous than in many other countries. And another feature of the US system is the small share of consumption taxes—compared with other OECD countries there is plenty of scope to raise indirect taxes. Environmental taxes are also a potentially important revenue source. According to some estimates, raising current fuel taxes to the OECD average could generate additional revenues of close to 1% of GDP in the US.
The US corporate tax system is also excessively complex. While there is a high marginal tax rate on corporate profits, the overall revenue from the tax is quite low. This clearly points to the need for an overhaul. It should be possible to lower the corporate tax rate and thereby reinforce the effects of a competitive exchange rate without sacrificing revenue (broadening the tax base).
Michael Heise, THE ECONOMIST



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