By now we're all aware that the federal government faces serious fiscal challenges in the coming decades. The Congressional Budget Office projects that under current law, spending on Social Security and major health care programs will increase from less than 10 percent of gross domestic product today to more than 20 percent of GDP in 2088. As a result, the federal debt will explode to almost 250 percent of annual GDP.
One popular view holds that we can deal with these challenges by making some small tweaks to entitlements, combined with a large tax increase on the top 1 or 2 percent of income earners. Unfortunately, it won't be that easy. Maintaining a large welfare state requires a large amount of revenue, and raising that revenue without increasing taxes on middle-income Americans would inflict severe economic damage.
Nearly all taxes distort people's choices by driving a wedge between true economic costs and benefits, but some taxes are more harmful than others. Taxes on capital income are particularly damaging because they punish saving relative to consumption, thereby reducing capital investment and the economy's capacity to produce output. Also, very high marginal tax rates on specific activities, or at particular ranges of income, can have large economic costs.
A government that raises only a modest amount of revenue can get away with using these costly taxes, if it wishes to do so. But raising large amounts of revenue from these kinds of taxes would cause serious harm and is not a realistic option. As a government raises more revenue, therefore, it must shift toward less costly taxes. That means taxing consumption or labor rather than capital, using less progressive taxes that spread the burden broadly throughout the population, and taxing activities that create negative spillovers for society.
Other countries have already encountered this tradeoff. As University of California at Davis economist Peter Lindert points out, countries with large welfare states – like Sweden, Finland and Denmark – tax capital income quite lightly. They rely on broad-based consumption and labor income taxes, and taxes on products – like alcohol, tobacco and gasoline – that create spillover costs for society.
The spending side matters too. Last year, policy makers agonized about the consequences of raising the top marginal tax rate from 35 to 39.6 percent. Meanwhile, nobody paid much attention to the high marginal tax rates at the bottom of the income distribution. For many low-income individuals, an increase in income can mean losing Medicaid, the Earned Income Tax Credit and other means-tested benefits. The loss of these benefits has the same economic impact as a tax, and in some cases, the marginal tax rate can be more than 80 percent. Starting in January, the phase-out of the Affordable Care Act's health insurance subsidies will have a similar effect.
How do countries with large welfare states deal with these issues? Lindert finds that they phase out government benefits more slowly as income rises, which means allowing individuals with higher incomes to receive some benefits.
The bottom line is that sustaining a large welfare state will be feasible only with a pro-growth tax system that taxes consumption rather than investment and spreads more of the tax burden over the middle class. It will also require carefully designing transfer payments so that they do not severely punish work.
In short, we face a choice. If we want to keep our current tax and benefit structure, which features a relatively high tax burden at the top and a low burden on the middle class, as well as welfare benefits that phase out rapidly with income, then we will need to sharply curb entitlement spending. If we're willing to move towards less progressive taxation, with a higher tax burden on the middle class and broader welfare benefits, then we can get by with more modest entitlement cuts.
Either way, though, there will be a burden on the broad middle class – entitlement cuts under the first approach and tax increases under the second. Reasonable people can disagree on which approach they prefer. But they must choose one or the other. That means setting aside the fantasy that we can finance dramatic entitlement growth while taxing only the rich.
Sita Nataraj Slavov is a resident scholar at the American Enterprise Institute.