Posted on Thursday, February 17, 2011
THE US does not face an imminent fiscal crisis. The US government will not default on its debts, and it’s even unlikely that the Fed will be forced to monetise federal debts. However our fiscal regime is becoming increasingly dysfunctional, thus radical reform would be quite helpful. I’ll sketch out what I view as ideal, with the understanding that political constraints will make actual reforms much more modest.
Despite 9% unemployment, a rapid move toward fiscal austerity in the US would be highly desirable. Before doing so, however, Congress and the Fed need to get on the same page regarding stabilisation policy. The government should give the Fed a desired trajectory for nominal GDP growth over the next 10 years, and instruct them to engage in level targeting, which involves making up for any near-term overshoots or shortfalls. This would anchor NGDP growth expectations, allowing Congress to sharply reduce the deficit without endangering the recovery.
The next step is to reduce expenditures. Obviously this is a political decision, but I’d favor much lower spending on the military, homeland defense, and agriculture. Programmes such as highways and K-12 education should be shifted back to the states. In the medium term we should gradually shift from an insurance-based system of medical expenditure (public and private) to a system where most medical expenditures are made out of health saving accounts, with catastrophic insurance plans covering the most expensive procedures. This could help restrain the growth of Medicare. Over the very long term we need to shift to a system of fully-funded private retirement accounts, on top of a basic annuity provided by the government. All fiscal reforms should be aimed at moving the US toward the low-tax, high-saving Singapore model.
Our tax system also requires radical restructuring. We need new consumption and environmental taxes, but adding them to our current tax regime would invite even greater distortions and inefficiencies. Instead I’d eliminate both the personal and corporate income taxes and replace them with a progressive consumption tax regime, comprised of three parts:
1. A progressive payroll tax, with an earned-income tax credit for low income workers.
2. A progressive value-added tax, with much higher rates on luxury goods.
3. A relatively steep carbon tax.
Obviously this sort of radical restructuring is not politically feasible, but some reform is likely over the next decade, due to the increasing inefficiencies of our current tax system. For instance, the US corporate income tax is now the highest among developed countries, but is also riddled with loopholes.
The tax plan I outlined has features that are attractive to both the left and the right, and thus provides a road map for future compromises. Republicans should insist that no new broad-based tax is added without first eliminating at least one of the existing (income) tax systems.
Democrats should insist that any new consumption taxes be progressive. Because reducing complexity and eliminating taxes on capital are both huge net gains for the economy, there are win-win compromises available if both sides are willing to deal.
Scott Sumner, THE ECONOMIST