Tax Reform

Currently, in the media, one of the hottest topics for political debate is the subject of tax reform. Currently in the United States, we are facing an enormous and growing budget deficit. The past 4 years have seen trillion dollar deficit growth every year. On top of that we face the problem of fiscal non-competitiveness in international markets. What I mean by that is our cost of living, cost of labor and cost of taxes makes the USA one of the most expensive places to do business on the planet. The obvious solutions to each of these problems are mutually exclusive. One implies budget cuts and/or tax revenue increases, the other greater government outlays to defray business costs and lower taxes to decrease the cost of doing business here.

The political results of both having a large deficit and having an extremely high cost of doing business have been partisan finger pointing and legislative deadlock. The reasons for this are that cutting budgets and raising taxes are politically untenable positions. Look at European austerity for an example as to why this is. For every government spending program there is an entrenched special interest fighting to keep it, and nobody likes higher taxes. A politician running on a platform of decreased government outlays AND higher taxes is looking at losing their election. The result in the USA in the past few decades has been ever increasing budgets with ever decreasing tax burdens. The fault is bipartisan, with George Bush raising spending to battle terrorists around the globe while cutting taxes, and Obama increasing federal outlays for welfare and healthcare programs while pushing through "temporary" tax relief measures. Even in the 2012 election, neither candidate embraced both higher taxes AND lower federal outlays.

As much fun as it would be to completely reform government and the tax code such that we returned to a limited federal government, increased states' rights with a political class truly answerable to the populace, this is not likely to happen. This is not the article where I espouse my pseudo libertarian ideals. Instead the focus here is working inside our current architecture to make intelligent budget decisions that can solve our problems with as limited a negative economic impact as possible.

So, what happens if we do nothing? The answer to this is, again, Europe. For the past 20 years, with a few notable exceptions, European countries have been increasing spending, increasing taxation and increasing social welfare programs. This won the existing governments many elections. Unfortunately, Europe is now paying for its profligacy. Portugal, Italy, Greece and Spain have all seen their cost of borrowing money on international markets explode while their economies have succumbed to the pressures of the great global recession and their own lack of productivity. The result has been the highly unpopular (to the point of social unrest) austerity measures with crippling new taxes and devastating budget cuts at the same time. These efforts have predictably resulted in worsening the European recession. For now the USA cost of borrowing is low, but there is no guaranty that this will remain so, especially as the rest of the world gets its fiscal house in order and there are alternatives internationally to investing in US debt. When our cost of borrowing does go up, we are going to go from a mere budgetary crisis, to a full on catastrophe.

The solution to this problem is, predictably, to raise revenue while decreasing outlays and decreasing the cost of doing business in the USA. Right now you may be thinking, didn't he say above that this was mutually exclusive? The answer is yes, at least if you accomplish these tasks in the obvious manner, by increasing tax rates and decreasing total government spending. Instead, government has to intelligently cut outlays and increase revenues.

The first way to accomplish this is to cap all deductions at a preset amount. According to the Tax Policy Center capping deductions at $25,000 per filer would raise an additional $1.3 trillion over 10 years, or about $130 billion a year. That is 13% of the current accounts deficit by itself. More over, by allowing up to $25,000 in deductions, most wage earners tax burdens wont be affected. Only the highest earners with the largest deductions will be affected.

The second way to cut the budget deficit is to cut foreign aid completely. In 2010, according to the Organisation for Economic Co-operation and Development, the U.S. gave about $30 billion in aid. By cutting this money and applying it to paying down the deficit we can lower account deficits by 3% a year. The benefit here is that there is very little domestic impact to the spending cuts. While this will not endear ourselves to the rest of the world, the rest of the world doesn't pay our taxes and isn't responsible for our deficits. It's one thing to be charitable when you are flush with cash, it is another thing entirely to be borrowing money from a loan shark to give money to ungrateful beggars.

The third way I propose to cut the deficit is to means test social security payments. 20% of our annual federal budget goes to paying social security benefits. If we means test the program and make payments only to seniors who are close to the federal poverty level we can likely clip half of this cost, or about $350-400 billion a year. This is fully 35% to 40% of the federal accounts deficit by itself. This is a huge amount of money, and it is currently being spent to subsidize the lifestyles of seniors who do not need the money (because I am proposing cutting only those outlays to seniors with incomes well above the federal poverty line). Social Security was designed as a recession era welfare program to keep the elderly from falling into abject poverty. By means testing this, we ensure that aide only goes to those seniors who are at risk for falling into poverty. The last thing we need is for government money going to pay a rich retiree's greens fees at the local country club.

The fourth way to raise revenues is to stop capping the income that is subject to the social security tax. In 2012 the income taxable for social security is capped at $110,100 according to the Social Security Administration's own web site. By uncapping this we can increase income by hundreds of billions of dollars a year without changing any tax brackets. It simply imposes the same tax at all income levels instead of only the first $110,100. This is tax parity at it's finest, everyone in America spending the same percentage of their income to support at risk seniors. More over it would ensure the long term viability of the system.

The fifth way to increase revenues  is to increase capital gains taxes from their current rate of 15% to a progressive capital gains tax referenced to income. By matching federal income tax rates and treating capital gains as income, the federal government will raise hundreds of billions of dollars in revenues. If there is concern about decreasing the incentive to invest, then the government can simply adjust capital gains rates to slightly below those of regular income to maintain an investment incentive. This also increases tax parity by making people who make a living from investments pay close to the same amount of taxes as those who earn their money in cash salaries.

OK, if you made it through all that tax information, you may be asking yourself, how does he intend to increase competitiveness? Because as he has it right now, this is just raising tax costs. The answer to this is to lower our least competitive and most destructive tax rate, our business tax rate. Currently the USA has a corporate income tax rate of 35% with each of the 50 states imposing additional state taxes on top of this. China has a 25% rate, Canada 31% total of federal and provincial, France 33%, United Kingdom 20-23%, you get the picture. Only Japan and Germany have comparable tax burdens on business, and Japan is in the midst of a decade without significant economic growth. The fact is that among most first world nations our corporate rate is outsized. By lowering this to 25% we will instantly become a much more competitive country to do business in. If we couple this by eliminating the US's tax on foreign earnings, a tax almost no other first world nation imposes, we create a large incentive for foreign companies to invest in the US, bring jobs to the US and give US companies a greater incentive to keep jobs and revenue on shore. While this provision will cost hundreds of billions a year, the first few years annyway, the hope is that the increased competitiveness will fuel job and income growth. This growth should negate some, if not all, of the negative federal income impact that this reform would create.

Lastly, we need to make cuts in our military spending. This year our government will spend around $1 trillion on defense spending (this number is subject to how you allocate government spending to defense and military). As we wind down the wars in Afghanistan, Iraq, and Libya (through NATO), some of this spending will decrease naturally. However, we can do more. Even a 10% cut in this budget will free up around $100 billion a year. Currently we spend between 5-10% of GDP on our military (again, depending on how you allocate spending numbers). In an era when even China is only spending about 2% of its GDP on its military, and they have the largest army on the planet, this seems excessive. Too much money is being spent too inefficiently with too little to show for it for this to be fully justified. We need to further right size our military and military programs and focus more on homeland defense instead of foreign occupations. It should not be the role of the United States to police the world, we can't afford it.

This is my general solution to the current problem facing America from a federal budget perspective. It includes revenue increases with welfare program reform and military budget cuts. This list is not exhaustive. There are many other areas of government that can and should be cut. Redundancies that can be smoothed out at net benefit to all. More over, this is a plan that I think could receive some bipartisan support (including both cuts and revenue increases). It is not necessarily ideal, as I pointed out earlier, but the ideal role of government will be the subject for another post. This is focused mostly on making adjustments to the current architecture of the federal government. In other words, this plan deals with the reality we face, not how I would make our government from scratch.