Questioning Obama's fiscal calculator

Mitt Romney will address the deficit by reducing spending and broadening the US tax base. Barack Obama will raise taxes on high income earners – but that won't be enough, so what else will he do?

FT.com

The release last month of the Congressional Budget Office’s update to the budget and economic outlook for the next decade rightly draws attention to the "fiscal cliff” – the large tax increases and spending cuts that are currently scheduled for January 1. But there’s more to the CBO report than its analysis of what may happen in the next few months.

The CBO analysed the consequences for deficits and debt over the next decade of keeping tax and spending policy on autopilot. Relative to the agency’s baseline, deficits would increase by almost $8 trillion over the next decade. And debt held by the public would reach about 90 per cent of gross domestic product; its highest level since the second world war.

Elevated federal spending is the source of the widening deficits over the next decade. The CBO estimates that revenues as a share of GDP would average about 18 per cent, roughly their 40-year average. Federal spending at 23 per cent of GDP would stand about 10 per cent higher than its 40-year average, 21 per cent.

Higher debt levels crowd out private investment. And they reduce household and business spending on account of higher expected future taxes to close the budget gap. The debt problem that the CBO identifies will get worse after the next decade with large and growing shortfalls in Social Security and Medicare. It is not an understatement to observe that the challenge of avoiding a high-debt, low-growth economy is the key domestic policy issue.

So what are the approaches of Governor Mitt Romney (who I advise) and President Barack Obama (who speaks tonight at the Democratic convention) to this central challenge?

Mr Romney’s budget (for which I wrote the foreword) focuses on reducing debt burdens and enhancing economic growth through spending restraint and tax reform. Mr Romney proposes to reduce federal spending as a share of GDP to 20 per cent by 2016 and gradually reduce the growth in Social Security and Medicare spending, particularly for more affluent households. The GOP candidate would reform the corporate and individual income taxes, reducing marginal tax rates by just under one-third for the corporate tax and by 20 per cent for the individual income tax, while broadening the tax base to make up lost revenue. The Romney plan addresses the deficit and debt challenge comprehensively, though both spending restraint and tax reform pose political challenges.

Mr Obama has proposed to continue current elevated levels of federal spending, while raising taxes on higher-income households and businesses to reduce the deficit and debt consequences of higher spending.

Indeed, Larry Summers, the president’s former chief economic adviser, recently argued in the Financial Times that reducing federal spending as a share of GDP is not achievable. Mr Summers pointed to demographic change (population aging), higher interest payments on the large public debt (which has increased substantially in the past few years) and increases in the relative price of health (a significant component of government spending). This view is consistent with Mr Obama’s budget, which assumes elevated levels of spending over his presidency and thereafter.

In contrast with Mr Romney’s plan, the president’s plan does not address medium-term and long-term deficit and debt problems. Taken at face value, the Obama plan will require acceptance of the costs of much higher levels of deficits and debt or substantial tax increases on all Americans. The CBO’s report shows the consequences for deficits and debt over the next decade of such continued budget inaction.

But the president is proposing higher tax burdens on certain households and businesses. Will those tax changes close the budget gap? No.

The president says he will raise marginal tax rates on upper-income workers and business owners (against the grain of tax reform efforts over decades, including his own Fiscal Commission, which argued for lower marginal tax rates financed by broadening the tax base). His proposed revenue increases include the "Buffett rule” (effectively a new alternative minimum tax on high-income taxpayers), tax increases on dividends and capital gains, plus raising the top income tax rate to its pre-2001 level.

What are those tax increases? The Buffett rule imposes a minimum effective tax rate on taxpayers with annual incomes over $1 million (most of whom already face a higher tax rate). For higher taxes on saving and investment, the president would raise taxes on capital gains to 20 per cent from 15 per cent and on dividends to 39.6 per cent from 15 per cent. Next, the president calls for restoring the pre-2001 tax rates for high-income individuals, including increasing the top marginal income tax rate to 39.6 per cent from 35 per cent. In addition, the president’s budget also calls for phasing out exemptions and lower-bracket tax rates for higher-income taxpayers, raising marginal tax rates further. And the president would limit certain tax deductions for individuals with incomes over $200,000.

Adding up the proposed tax increases on upper-income taxpayers should raise $148 billion per year in additional revenue, according to US Treasury department estimates. Viewed next to proposed additional spending by the president of roughly $500 billion per year, Mr Summers’ claim that federal spending will remain high, or this year’s federal budget of $1.1 trillion, the president faces an arithmetic challenge.

Assuming the Obama administration wanted to close the budget gap – to be comparable with the lower deficits in the Romney plan – what additional tax increases would be required? To begin, let’s call the maximum additional revenue from upper-income taxpayers $148 billion per year, as the administration has not identified more tax increases on those taxpayers.

To close the budget gap, one could raise additional revenue by broadening the tax base. But the president’s proposals already accomplish much of that for upper-income taxpayers. Additional tax base broadening would be required for middle-income taxpayers. Of course, the administration could propose an increase in marginal tax rates. Unless, though, the administration wants to raise marginal tax rates further on high-income individuals, marginal tax rates would have to be raised – and substantially – on middle-income taxpayers. Of course, the deficit and debt could simply be allowed to rise, not a sustainable long-term solution for the country.

The choices of the size of government and how we pay for it are fundamental ones. They are also the ones we should be analysing and debating. Mr Romney has proposed a plan of fiscal consolidation and tax reform. Accomplishing it will require reducing the growth of federal spending and broadening the tax base. These changes will not be easy. Mr Obama proposes a larger government with explicitly higher taxes on high-income taxpayers but, by the arithmetic of higher spending levels, eventually higher taxes on all Americans.

Glenn Hubbard is an American economist and academic professor. He is currently the dean of the Columbia University Graduate School of Business.

Copyright The Financial Times Limited 2012.