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A Tax Increase without the Pain

Wednesday, May 16, 2012

Here’s the best way to address the nation’s unfunded liabilities for Medicare and Social Security.

Each year, the federal government summarizes its financial condition in the Financial Report of the U. S. Government. In recent years, the number that has attracted significant attention is the report’s estimate of the present value of the government’s “unfunded liabilities” for the next 75 years—the present dollar value of the funding shortfall in Social Security, Medicare, and Medicaid over that period if current policies were to remain unchanged.

The fiscal 2011 report estimates the net shortfall to be $6.4 trillion (see page 153 of the report). It’s a number that has been setting off alarm bells, but it’s also a number that is prone to misinterpretation. It is not a forecast; instead, it is a what-if scenario: “What if current policies didn’t change for 75 years and the growth rate settled into an unimpressive annual rate of 2.2 percent?”

In any case, there is near-unanimous agreement among politicians and pundits that current policies would result in an unsustainable debt-to-GDP ratio (see page x of the Citizen’s Guide in the 2011 report), which in turn begs the question of how we can fix this scenario before it’s too late. House Republicans have tried to get a conversation going, but the Democrats apparently want to put that conversation off until some unspecified time after the election.

There is near-unanimous agreement among politicians and pundits that current policies would result in an unsustainable debt-to-GDP ratio.

The good news is that the lull in the political dialogue gives us a chance to consider an important aspect of the financial report, one that has been overshadowed by the media’s focus on the calculated unfunded liabilities: The report all but ignores alternative economic growth scenarios, giving few if any clues as to how much difference more-robust growth would make in the long run.

The shortage of analysis around the effects of higher economic growth is nothing new—it has been noted in every year’s report going back to at least 1998, in phrasing nearly identical to that on page 11 of the latest report, which states that one asset intentionally excluded from the federal balance sheet is “the financial value of the government’s sovereign powers to tax.” It is excluded from the assets because nobody can predict how the tax laws or the size of the tax base might change—especially over the next 75 years. But that doesn’t mean it isn’t important; it just means it’s too unpredictable to yield a reliable estimate of its asset value.

Nonetheless, a subtle but important implication of the government’s “sovereign power to tax” is that even when tax rates remain unchanged, the government enjoys higher tax revenues from a faster-growing economy. The year 1998 demonstrated that effect of economic growth; that year’s report confirmed the pleasant surprise delivered by a better-than-expected economy, which “over the course of the year brought a surge in tax revenue in 1998.” It was a surprise, growth-driven surge in tax revenue that helped generate the late-1990s’ fiscal surpluses.

The lesson we can take from the 1998 Financial Report of the U.S. Government is that growth is a “tax increase” without the pain of a tax rate increase. For the nation’s workforce in 1998, growth meant an aggregate increase in take-home pay as well as an increase in taxes paid to the government. With results like that, it’s no wonder that virtually every politician across the political spectrum supports better economic growth—when asked.

Why, then, are alternative growth scenarios difficult at best to find in this year’s financial report? Why do the basic assumptions in the actuarial analysis merely yield a conservative (i.e., pessimistic) growth result of 2.2 percent (page 136)? Alternative growth scenarios get only brief mention on page 157 of the report.

The report all but ignores alternative economic growth scenarios.

One way to paraphrase it might be, "a lot depends on the size of the future labor force and on productivity; also, higher productivity might not be a sufficient solution; lastly, some spending is tied to rising wages, offsetting some of the revenue gain. Therefore, growth effects are unclear at best."

Such a summary would make it sound as if the report’s analysis of unfunded liabilities was heavily influenced by the “exogenous growth” school of economic thought—the school that essentially says "look, growth happens mostly because of external forces, and when it turns out to be better than expected, as it did in 1998, we should consider it a pleasant surprise, a benevolent bolt from the blue."

That line of thinking might be good enough for the exogenous growth crowd, but there’s an alternative school of thought, the brainchild of economist Paul Romer, called “endogenous growth”—which essentially says “Wait a minute; we don’t have to sit and hope for benevolent meteors. We can actually influence the growth rate by implementing the right policies.”

One example: Because math, science, and engineering skills are crucial to any society’s future improvements in standard of living, why not staple a green card to college diplomas in those fields earned in American universities by foreign students—to encourage them to stay right here and help us make our future better, instead of returning to their home countries to apply their skills? Another idea is to provide government subsidies for math, science, and engineering education.

There are plenty of growth-enhancing ideas, but they don’t get sufficient exposure when the debate about so-called unfunded liabilities ignores the power of higher growth rates to help with the funding.

Futurist Ray Kurzweil made a prediction about near-future growth rates in his recent book, The Singularity Is Near:

Before the middle of this century, the growth rates of our technology... will be so steep as to appear essentially vertical. From a strictly mathematical perspective, the growth rates will still be finite but so extreme that the changes they bring about will appear to rupture the fabric of human history.

Economist Arnold Kling’s reaction to Kurzweil’s prediction was telling:

If Kurzweil is correct, then the mountain of debt that we fear we are accumulating now will seem like a molehill by 2040. We will pay off this debt the way someone who wins a million-dollar lottery pays off a car loan.

Needless to say, not all economists share Kurzweil’s views about future growth potential. But that’s not the point; what’s important is that the power of growth should secure it a higher priority on the agenda.

Robust growth, as in 1998, can mitigate or solve a lot of problems—which strongly suggests adding alternative scenarios to the actuarial analysis in the government’s financial report, if only for the purpose of revealing the sensitivity of the actuarial analysis to the basic assumptions affecting the growth rate.

At least two new what-if questions come to mind:

(1) What if we could achieve real economic growth rates similar to those in the late 1990s, instead of the unimpressive “conservative” rate derived in the report’s analysis (around 2.2 percent)?

(2) Just to put a hypothetical upper bound on the problem, what changes in basic assumptions would yield sufficient funding for all of the liabilities without increasing any tax rates? (Assumptions such as immigration rates, productivity rates, unemployment and workforce participation rates, etc.)

If the financial report included those alternative scenarios in the actuarial analyses, voters would be in a much better position to judge which policies and candidates would be more effective at encouraging the economic growth we need. The debate about fixing our unfunded liabilities would not then be limited to the issue of how to cut liabilities—it would include which new growth policies could help fund them.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy.

FURTHER READING: Conover also writes “The Debt Ceiling Distortion,” “The Unfairness of the Buffett Tax,” and “What Does ‘Fiscal Responsibility’ Mean?” Joseph Antos discusses “Medicare's Fiscal Crisis and Options for Reform.” Michael Barone says “Voters Want Growth, not Income Redistribution.” Alan D. Viard and Chad H. Hill contend “Pro-Growth Tax Reform can be Progressive.”

Image by Rob Green / Bergman Group

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