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How the U.S. Could Stabilize Debt and Fuel Economic Growth

Oct 23, 2023 | Public | 0 comments

Each time the U.S. government comes perilously close to a shutdown because of disagreement within Congress on raising the federal debt ceiling, a familiar question arises: Could we not fix the debt issue once and for all? Yes, it can be resolved with some bold steps that will also bring some bonus benefits, according to a new brief by the Penn Wharton Budget Model (PWBM), a nonpartisan policy thinktank.

The PWBM brief, titled “A Wide Range of Policy Bundles Can Stabilize Federal Debt While Growing the Economy,” details three options that could potentially contain the debt-GDP ratio at between 95% and 150% by 2050 — instead of the projected 190%. The measures proposed in the options would work at both ends: increase GDP and wages, and reduce debt and spending. If enacted in 2024, those options would bring in new revenue of between $4.3 trillion and $5.6 trillion within a 10-year budget window.

But one option that is no longer available is not doing anything now, warned Kent Smetters, PWBM policy director and Wharton professor of business economics and public policy. The current federal debt problem is “very different than COVID and the [2008] financial crisis,” he said on the Wharton Business Daily radio show that airs on Sirius XM. (Listen to the podcast.)

“In those crises, we just printed [more money]; we just increased the debt,” Smetters recalled. “[But now], when the problem is caused by debt itself, you can’t just issue more debt to get out of it. That just leads to hyperinflation. And so it’s a serious, very predictable problem that we’re on. And it just requires action being taken right now.” Another PWBM brief from October 6, 2023, titled “When Does Federal Debt Reach Unsustainable Levels?” estimated that “financial markets cannot sustain more than the next 20 years of accumulated deficits projected under current U.S. fiscal policy.”

“Debt ceiling debates would become less frequent if Congress adopted fiscal measures that limited the growth of federal government debt relative to the size of the economy,” the PWBM brief stated. The current debt ceiling is $31.4 trillion, and it has always been deployed to restrain unchecked spending, except during war years. The latest truce, pushed through with much difficulty this past June, suspends the debt ceiling through January 1, 2025, while holding spending flat in 2024. That resolved an impasse built up in the months leading up to June, caused mainly by a shortfall in tax receipts, according to a PWBM report in May.

Social Security, Deductions Among Uneasy Targets

The PWBM options contain some politically unpalatable measures: Raise taxes, especially on the super-rich. Expand the tax base. Introduce a value-added tax. Remove some itemized deductions. Reform Medicare and Social Security so that they don’t disincentivize employment. Shave a bit off discretionary spending on programs such as for transportation and housing.

The PWBM brief outlined how the debt-GDP ratio would decline and the economy grow under each of its options. Option 1 would allow the debt-to-GDP ratio to grow from 100% today to 150% in 2050, which means that fully stabilizing debt requires additional reforms. Option 2 fully stabilizes the debt-to-GDP ratio, and in fact decreases it to 95% by 2050. Option 3 also roughly stabilizes the debt-to-GDP ratio at its 2024 value, and it uses policy levers outside of Social Security and Medicare. All three options raise more revenue from, or provide less spending to, higher-income households relative to lower-income households.

“When the problem is caused by debt itself, you can’t just issue more debt to get out of it. That just leads to hyperinflation.”— Kent Smetters

PWBM analyzed the impact of tax and spending measures under various scenarios, including behavioral responses, with a model it developed that represents “hundreds of thousands of different types of households, differentiated across 60 demographic and economic attributes.”

Here are the highlights of the estimated outcomes of the PWBM options, assuming they are implemented in 2024:

Option 1: Increase Taxes on High Income

  • Raise the top income rate on ordinary income from 37% to 45%.
  • Tax capital gains and dividends at ordinary rates and tax gains at death. Current law has preferential tax rates for capital gains held for a minimum period and qualifying dividends; it also changes the treatment of unrealized capital gains when assets are transferred at the time of the holder’s death.
  • Expand the base of employment taxes to cover all pass-through income. With this move, income from pass-through businesses can no longer avoid self-employment payroll taxes and the net investment income tax.
  • Reduce the estate tax exemption from $12.9 million to $3.9 million.
  • Introduce a third income bracket under the Alternative Minimum Tax (AMT) system, taxing at 45% above $1 million.
  • Raise the corporate tax rate from 21% to 28%.

This option would generate almost $4.3 trillion over the next decade. By 2050, GDP is projected to be 2.2% larger than under current policy with growing debt, while wages would grow by 2%. This policy bundle fails to stabilize the debt-to-GDP ratio, which would grow from 100% in 2024 to 150% in 2050, but it would still be lower than the 190% it would swell to without policy reforms.

Relying merely on populist measures like taxing the rich won’t make the cut, Smetters said. “It does grow the economy a bit, but it’s not going to grow as much as things like reducing some spending as well,” he said. “Because higher taxes also compete for capital, they will distort incentives to save and incentives to work. But the bottom line for the tax route is that if, in fact, you’re just trying to tax millionaires and billionaires, there’s simply not a deep enough pool there. They already face pretty high marginal tax rates, especially after accounting for state and local taxes.”

Option 2: Entitlement Program Reforms

  • Slow Social Security expenditure growth by indexing benefits to chained CPI: Here, Social Security benefits will be adjusted for inflation each year using a different version of the Consumer Price Index (CPI) called “chained CPI,” the measure used to adjust most parameters of the tax system.
  • Make the Social Security benefit formula more progressive: The idea here is to change how benefits are calculated over 30 years in order to provide more generous benefits for lower career earners and less generous benefits for higher career earners.
  • Raise the full-benefit Social Security retirement age from 67 to 70: Here, for people born in 1960 or later, the full retirement age would increase by two months every year until it reaches 70.
  • Raise the Social Security payroll tax rate from 12.4% to 14.4%, split evenly across workers and employers.
  • Double the Social Security taxable maximum earnings threshold: This change would apply the Social Security payroll tax rate for workers and employers on the worker’s first $320,000 of wages in 2023, double the current cap of $160,200 (adjusted each year for inflation).
  • Raise the Medicare retirement age from 65 to 67. This change would not disturb the qualifying parameters for individuals with certain disabilities.
  • Allow Medicare to negotiate drug prices beyond existing provisions contained in the Inflation Reduction Act: This change would expand the government’s authority to negotiate prices of all drugs with manufacturers from the current policy that covers only a select set of drugs.

This option would generate almost $4.1 trillion in new tax revenues over the next 10 years. GDP will shrink 0.5% in the short run but reverse course and become 4.4% larger by 2050. This bundle stabilizes the debt-GDP ratio throughout the entire projection period, ultimately reducing it to 95% in 2050.

If this policy bundle is adopted, households must replace some Social Security income with additional private savings, or what is called “crowd-in” of capital, the brief pointed out. This will of course be easier on households facing fewer borrowing constraints, including higher-income households that are relatively more impacted by the changes in Social Security benefits. Households must also work for a longer period of time, which adds to the economy’s labor supply and total production capacity, the brief added.

“There will be some sacrifice, there will be pain, but there will be a lot more of that if the government doesn’t take action.”— Kent Smetters

“[Social Security and Medicare are] always the third rail of politics, but nonetheless, there are ways of doing adjustments in both programs [so] that you could actually be progressive in particular, and even have a larger benefit for lower-income people,” Smetters said. “That would require smaller benefit for higher-income people while gradually increasing the retirement age (for Social Security benefits), as well as potentially increasing the payroll tax a bit. [They can] deliver powerful effects on the budget as well as the economy.”

According to Smetters, the evidence shows that increasing the retirement age to qualify for Social Security payments will persuade people “to work a little bit longer and save a little bit more for retirement.” It is also consistent with the trend of increasing lifespans, he added. “One reason why a lot of households right now have very little saving is precisely because it actually turns out that that’s rational,” he continued. Social Security and Medicare are “generous enough” to act as a disincentive for many households to save more, he explained.

Option 3: A Mixture of Broad-based Tax Increases and Spending Cuts

  • A 1.5% value-added tax (VAT): This would be a broad-based consumption tax of 1.5%, with exemptions for certain categories such as government health expenditures.
  • Disallow all itemized deductions: Under current law, when individuals calculate their income tax liability, they can take either the standard deduction or itemized deductions including those for mortgage interest, state and local taxes, and charitable contributions. This policy change would disallow all itemized deductions, and all taxpayers would have no option but the standard deduction.
  • Cut annual discretionary spending by 5%: This would apply to about 30% of the budget, of which half is defense spending and the other half is made up of education, transportation, housing, and other “discretionary” programs. All of those would see a 5% cut each year.
  • Cut annual infrastructure investment by 10%: Federal investments in physical infrastructure and grants for those activities to state and local governments would see a 10% cut.

This option would raise nearly $5.6 trillion over 10 years. GDP would grow in the short run and by 2050, it would be 1.9% higher than now (or baseline). The debt-to-GDP ratio would remain roughly flat over time, rising by just five percentage points from 100% in 2024 to 105% in 2050. Significantly, this option reins in the debt-GDP ratio without disturbing the Social Security or Medicare programs.

The U.S. is an outlier in that it does not have a value-added tax “at any significant level” at the federal level, Smetters said. “Most countries to the south of us [in South America] and most European Union countries have a value-added tax,” he added. “If your primary way of trying to deal with this increased debt is to mainly raise taxes, it would be very hard to do without something like a value-added tax or a broad-based income tax.”

The U.S. is also “a bit unique” in that it has spending provisions that are implemented through the tax code, such as the earned income tax credit, or housing subsidies, Smetters continued. “That has some historic politics behind it. It’s a spending program, but it looks like a tax cut. So both parties could get on board with it. But the problem is that it has so dramatically reduced the size of our tax base that we need these higher tax rates — and those cause distortions to savings and labor supply.”

A better alternative is to widen the tax base, Smetters said. “That would mean getting rid of everybody’s favorite deductions like mortgage interest, and maybe even the health deduction at the employer level. That would greatly broaden the tax base and allow you to get away with not having higher rates.”

No Time to Waste

Smetters put the PWBM’s options in the context of the current debt trajectory of the U.S.; it does not advocate on what policymakers ought to do. “The growing debt itself will contract the economy,” he said. “And because debt is climbing so much, that debt will compete with private capital for international capital flows and household savings in the U.S. economy, and reduce economic growth. Relative to that baseline, there’s a whole range of options — from increasing revenue to spending cuts and some mixture in between, too — that we can use to grow the economy.”

That path won’t be easy, for sure. “There will be some sacrifice, there will be pain, but there will be a lot more of that if the government doesn’t take action,” Smetters said. “If in the next 20 years we don’t take very decisive actions, the U.S. will have to default on its debt, regardless of debt ceiling limit agreements. It will either not be able to make interest payments, or it will implicitly default by monetizing and creating significant inflation. It is easier to do it right now than to wait for a few years.”


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