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This paper is part of a new initiative from the Peterson Foundation to help illuminate and understand key fiscal and economic questions facing America. See more papers in the America's Fiscal and Economic Outlook series.
In 2020, according to figures from the Congressional Budget Office (CBO), the federal debt skyrocketed to more than 100 percent of annual GDP for the first time since World War II, up from 79.2 percent in 2019. The debt buildup was driven by spending increases related to the COVID-19 pandemic — increases that were generally viewed as justified during an unprecedented emergency.
Even prior to the pandemic, however, the debt had been rising steadily. In 2019, at the peak of the business cycle, the federal deficit amounted to almost a trillion dollars. As the pandemic recedes, CBO projects that the debt-to-GDP ratio will level off temporarily but then continue its relentless growth, reaching more than 200 percent of annual GDP by 2051.
The projected growth in debt reflects a large and growing imbalance between future spending and taxes under current law, largely fueled by the aging of the population and the growth of healthcare costs. This fiscal imbalance has real costs. It reduces private investment and long-term economic growth, and it increases the risk of a financial crisis. Failing to address the fiscal imbalance imposes burdens on future generations that many would consider unfair.
The choices required to achieve a sustainable fiscal outlook will be difficult for people of all political stripes. In this essay, I argue that a sensible political compromise should include reducing Social Security and Medicare benefits for those with higher lifetime incomes, combined with tax increases designed to minimize harm to the economy. Those tax increases might include the adoption of a value added tax or a carbon tax, which are more growth-friendly, but less progressive, than income tax increases.
As my American Enterprise Institute (AEI) colleague Alan Viard and I argued in a recent article in Tax Notes Federal, government borrowing involves a tradeoff: it benefits current generations at the expense of future ones. While there is no formula to determine the appropriate level of government debt, economists and other scholars across the political spectrum have expressed concern about the large and growing fiscal imbalance under current law.
Government borrowing competes with private sector borrowing, crowding out private investment and lowering economic growth. To be sure, foreign investors’ willingness to hold U.S. government debt somewhat mitigates the consequences for the domestic economy. However, the projected ballooning of debt over the coming decades, combined with a lack of political will to address it, could undermine investors’ confidence, precipitating a financial crisis.
Moreover, when policy makers delay difficult decisions about how to address the fiscal imbalance, they impose a real cost on young and middle-aged people who are trying to plan their futures. I recently co-authored two studies showing that policy makers’ indecision on Social Security reform can impose a significant burden on young and middle-aged people trying to plan for retirement. As John B. Shoven, John G. Watson, and I argued in one of these studies, the direct cost of Social Security reform cannot be avoided; the only real decision is how to distribute that cost across groups and generations. However, the cost of government indecision can be avoided by committing to a plan for dealing with the program’s financial shortfall. Yet policy makers from both parties have failed to do so.
Since 2011, real interest rates (interest rates net of inflation) on government bonds have been consistently below 1 percent. While these low interest rates make government debt less costly and may increase the sustainable level of debt, most economists agree that low interest rates do not allow policy makers to avoid hard choices. The Chicago Booth School’s Initiative on Global Markets regularly surveys an ideologically diverse panel of economists on policy questions. In 2016, that panel was asked to indicate their degree of agreement with the following statement: “Long run fiscal sustainability in the US will require some combination of cuts in currently promised Medicare, Medicaid and Social Security benefits and/or tax increases that include higher taxes on households with incomes below $250,000.” A clear majority either strongly agreed or agreed, while only 3 percent disagreed.
Some polls suggest that there may be significant public support for reducing Social Security and Medicare benefits for those with higher incomes, a reform that is sometimes referred to as “means testing.” Numerous proposals along these lines have been discussed. Making benefits more progressive would be a sensible way to reduce cost growth while protecting those with lower incomes. However, measures to increase progressivity must be carefully designed to avoid unintended consequences.
Both Social Security and Medicare already include features that increase the progressivity of benefits. First, an individual’s monthly Social Security benefits are based on the average of their top 35 years of earnings, indexed to economy-wide wage growth. This average can be thought of as a proxy for earnings over a person’s lifetime. A progressive benefit formula is applied to this average. The formula results in monthly benefits that increase with lifetime earnings; however, lower-earning individuals receive larger monthly benefits as a fraction of their lifetime earnings than higher-earning individuals. Second, once an individual qualifies for Medicare, benefits are not tied to any measure of lifetime earnings, which means that benefits are a much larger share of earnings for lower-income individuals than for higher-income individuals. Third, beneficiaries with high annual incomes must pay income tax on a portion of their Social Security benefits. Finally, Medicare beneficiaries with higher annual incomes pay premium surcharges.
As Alan Viard and I argued in a series of two articles in Tax Notes Federal, additional progressivity in Social Security and Medicare should be based on lifetime earnings rather than annual income. Means testing that is based on beneficiaries’ annual income punishes work at older ages and saving for retirement. It also incentivizes individuals to manipulate their income by altering the timing of retirement account withdrawals and Social Security claiming. Lifetime earnings measures are less sensitive to the timing of earnings and therefore less vulnerable to manipulation. Moreover, lifetime earnings are more indicative of a person’s ability to pay and need for assistance because fluctuations in annual earnings are smoothed out.
Additional progressivity in Social Security could be accomplished by flattening the existing relationship between monthly benefits and the lifetime income measure on which they are based. In the Tax Notes Federal series, we advocated going even further and paying a flat monthly benefit. Other observers have made similar proposals, including my AEI colleague Andrew Biggs, and researchers at the Progressive Policy Institute. Such a policy could avoid disincentivizing long careers by tying the flat benefit to career length, as the Progressive Policy Institute’s plan does.
Any sensible compromise to address the fiscal gap must include revenue increases in addition to benefit cuts. However, revenue should be increased in a way that limits the distortion to economic incentives even if it reduces the progressivity of the tax system. Options along these lines include a value-added tax, which creates less distortion by taxing consumption rather than saving, or a carbon tax, which incentivizes people to consider the social cost of carbon emissions.
The U.S. tax system is highly progressive compared to the tax systems of other high-income countries, in the sense that the highest-income individuals bear a large share of the tax burden. However, our fiscal system does less redistribution than the fiscal systems of many other countries. This apparent paradox arises because the amount of redistribution induced by a tax system depends on its size as well as its progressivity. Scaling up a progressive tax system causes a direct reduction in inequality. Moreover, larger tax systems — whether they are progressive or regressive — indirectly reduce inequality by generating more revenue to fund transfer programs, which tend to be highly progressive. Because the U.S. tax system is relatively small, it induces less redistribution despite its greater progressivity.
To see this point more clearly, consider a nation that collects only $1 in tax revenue, imposing the entire burden on the highest-income individual, and redistributes the revenue to the lowest-income individual. Such a tax system is highly progressive, as the highest-income individual bears 100 percent of the tax burden. However, it barely reduces income inequality because only one dollar is transferred. Similarly, the U.S. tax system is highly progressive, but its small size limits the amount of redistribution it induces.
In another series of articles in Tax Notes Federal, Alan Viard and I provided a detailed discussion of these issues and argued that the small, progressive tax system in the U.S. is a result of political compromise between Democrats, who emphasize tax progressivity, and Republicans, who emphasize low taxes. The Democrats’ focus on progressivity is driven by concerns about how much income the highest earners receive compared to the middle class, as well as whether high-income individuals are paying their “fair share” of taxes. The Republicans’ focus on tax cuts comes from their concerns about the size of government.
However, this compromise is not conducive to addressing the long-run fiscal imbalance. As Viard and I argued, a larger and less progressive tax system may be a better compromise between the two parties. All else equal, highly progressive taxes do more to distort economic incentives, so using them to raise large amounts of revenue would do significant harm to the economy. In contrast, the value added tax systems found in other high-income countries do less economic damage; because they tax consumption, they do not distort the incentive to save and invest the way an income tax does. Similarly, a carbon tax corrects a market failure by incentivizing people to consider the impact of their choices on climate change. These taxes are less progressive, or even regressive. But a larger tax system could put transfer programs on a sustainable path (which supports Democrats’ emphasis on distribution), while a less progressive tax system would do less to distort incentives (which supports Republicans’ emphasis on economic growth). Under such a compromise, policy makers on both sides of the aisle would need to drop their commitment not to raise taxes on the middle class.
In recent years, teenage environmental activist Greta Thunberg has drawn attention to the cost to future generations of delaying action on climate change, arguing, “The grown-ups have failed us.” A similar logic applies to the failure to address the long-term fiscal imbalance, which also imposes costs and risks on future generations. Policy makers should act now to tackle this growing problem. A sensible compromise would include cutting social insurance benefits for higher-income individuals and increasing revenue in a growth friendly, but less progressive, way.
Policy makers should not shy away from such a compromise, thinking that the public would never get on board with it. In 2012, my Schar School colleague Siona Listokin, and her co-author Yair Listokin, administered a survey to a nationally representative population, asking respondents to select a set of policy options that reduce the deficit by a particular target. In contrast with most polls, this one forced its respondents to grapple with difficult economic tradeoffs. The results suggest that — when presented with these tradeoffs — people are generally supportive of reforms that broaden the tax base and make the tax system more growth friendly. For example, majorities supported introducing a national sales tax, introducing a carbon tax, and eliminating the deductions for home mortgage interest and state and local income taxes.
In their presentation of the results, the authors note the importance of making tradeoffs explicit: “People may hate the idea of a carbon tax in the abstract, but when faced with the alternatives for raising revenue, more than half of them support it.” Policy makers should similarly be honest about tradeoffs, offering leadership that steers the nation towards making these difficult choices sooner rather than later.
Acknowledgments: I thank Slavi Slavov, Michael Strain, and Alan Viard for helpful comments.
Sita Slavov is a professor at the Schar School of Policy and Government at George Mason University, a research associate at the National Bureau of Economic Research, and a non-resident senior fellow at the American Enterprise Institute. She has previously served as a senior economist specializing in public finance issues at the White House Council of Economic Advisers and a member of the 2019 Social Security Technical Panel on Assumptions and Methods. Her research focuses on public finance and the economics of aging, including issues relating to older people’s work decisions, Social Security, and tax policy.