Deficit Hawk, Progressive Style, Part II

As I wrote in Part I, the deficit hawks legitimately claim that huge deficits will hinder investment and kill jobs. But their solutions would make matters worse. What are those solutions? What are alternatives? A leading hawk, C. Fred Bergsten of the Peterson Institute for International Economics, proposes three control measures: containing Medicare and Medicaid costs, “comprehensive Social Security reform, including gradual increases in the retirement age and an alteration of the benefits formula” and a national consumption tax.

The hawks are right that we need to control all–not just public–health care spending, but only as part of national health reform. They are wrong about Social Security, which does just fine under any reasonable projections. They’re especially wrong about a consumption tax.

A consumption tax is essentially a national sales tax. Why a consumption tax? Because, the argument goes, it will encourage more saving. More saving will engender more investment. Of course, as even proponents recognize, a consumption tax hits poorer people harder, because they consume proportionately more of their income.

There’s little evidence a consumption tax will encourage saving and investment, let alone productive investment. To see why, consider the main reason that U.S. saving and investment fell so low in recent years: the real estate bubble. Middle class homeowners thought they were saving through the appreciation of the land under their houses. So why put aside a portion of their wages? Banks and other investors thought they were investing by buying up high-yield mortgage-based securities. So why lend at lower returns to productive businesses? In fact, real estate bubble investments closely resemble investment in government debt: both are passive investments, parasites on the real economy.

Here are three alternatives to the conservative hawks’ program of entitlement-cutting and consumption taxes: 1. Cut military spending. 2. Restore progressivity of federal taxes and raise rates, and 3. At state and local levels, rediscover the original wealth tax–the property tax.

1. Cut military spending. Dollar for dollar, military spending generates the fewest jobs and creates the most waste. Even strong advocates of a second “stimulus” wouldn’t demand more military pork. Chart III (click to enlarge) shows military spending from 1940 to 2013, in 2005 dollars and as a percentage of GDP. Cutting military spending both absolutely and relative to GDP helped Clinton lower debt and stimulate the economy. Obama seems headed the other way.

2. Restore the progressive income tax system. Since World War II, the federal income tax system has both declined as a proportion of GDP, and grown steadily less progressive. Top rates of the official income tax have fallen from over 90% to 35%, and unearned income like capital gains gets special low rates or disappears into loopholes. Meanwhile the other income tax–the payroll tax supporting Social Security and Medicare–has grown larger than the official income tax itself! The payroll tax hits all earned income up to a cap, now $106,800. The payroll tax rate, 2% in 1937 at the start of Social Security, has risen to 15.3%. Some two thirds of American families pay more payroll tax than income tax. Chart IV (click to enlarge) shows how the payroll tax has overtaken the official income tax as a source of federal revenue.

Conservative economist Greg Mankiw wrote in a recent New York Times op-ed that “Higher tax rates mean reduced work incentives and lower potential output.” That’s true, but only at the lower end of the income scale, not the upper. (Can you imagine a CEO saying, “If you cut my pay by $1 million, I’ll go home early on Friday”?) The payroll tax has become the ultimate killer of small business and low wage jobs.

Federal taxes as a percentage of GDP have hit a historic low, well under 20%. There’s plenty of room to raise taxes and make the system much more progressive. To do so, we should: a. Reinstate high progressive rates for the regular income tax. b. Cut or eliminate payroll taxes at the lower end, and remove the cap.

3. At state and local levels, rediscover the property tax. The property tax? Despite much rhetoric to the contrary, the property tax really is a tax on property–including corporate property (about 50% of the base). It’s a wealth tax, intrinsically the most progressive tax we have. Until World War II, it was the most important tax in the US. Since then, as Chart V (click to enlarge)  shows, sales and income taxes have substantially displaced the property tax. But as also evident in Chart V, the property tax doesn’t fall off in recessions as do income and sales taxes–if states had stuck with the property tax, as has New Hampshire, they wouldn’t be in their present fiscal jam. As an added bonus, because the property tax hits land values, it checks the false savings of real estate bubbles–encouraging real saving!

Conclusion: If we want to reduce debt, lessen inequality, stimulate small business investment and create jobs, here’s how to do it: cut military spending; restore progressivity and raise rates in the income tax system; and resurrect the property tax. Politically impossible? Only if it’s unthinkable!