Making Tough Fiscal Choices to Protect Future Generations

This paper is part of an initiative from the Peterson Foundation to help illuminate and understand key fiscal and economic questions facing America. See more papers in the Expert Views: Fiscal Commission series.

Sita Slavov1

November 13, 2023

Every Econ 101 course starts with the observation that tradeoffs are a fact of life. Whether at the individual or societal level, having more of one desirable thing generally means having less of another. One of my colleagues used to drive this point home every time a student made a case for more of something. Regardless of whether the student was arguing for more education spending, more infrastructure projects, more border security, or more tax breaks, my colleague would follow up by asking, “So, what do you want less of?”

Unfortunately, the U.S. government’s easy access to credit has enabled policy makers — at least in the short term — to avoid this question. The federal debt held by the public has skyrocketed from 35 percent of annual GDP just before the Great Recession to 98 percent today. The future looks even worse. The Congressional Budget Office projects that under current law, the federal debt will grow to an unprecedented 181 percent of annual GDP by 2054. This increase in borrowing — driven primarily by imbalances in the major federal health care programs and Social Security — is a serious problem. It harms future generations, limits policy makers’ ability to respond to emergencies, and puts the nation at risk of a financial crisis.

During the recent showdown over funding the government, some Republicans broke with their leadership and demanded “serious spending cuts,” which may have led casual observers to conclude that these lawmakers were bravely fighting the fiscal imbalance. But the only cuts under consideration were to discretionary spending — which amounts to only about a quarter of current federal expenditures (and less going forward). One of the key flash points — aid to Ukraine — is a small fraction of even that sum. Despite their rhetoric, these Republicans kept the major health care programs and Social Security — popular, broad-based, mandatory spending programs — off limits.

While a political battle under a tight deadline probably isn’t the right setting to consider reforms to these programs, the looming federal fiscal imbalance is far too big to be solved by cutting aid to Ukraine, cutting discretionary spending more broadly, or (as President Joe Biden has advocated) raising taxes only on those making more than $400,000. Moreover, those who argue that we must start with one of these specific, narrowly targeted measures before even considering anything else are missing the point. Genuine reform requires thinking holistically about the budget. It requires a willingness to scale back programs that enjoy broad public support, and to raise taxes on the broad middle class. And most importantly, it requires a spirit of compromise.

Fortunately, some policy makers have recently expressed interest in creating a bipartisan fiscal commission to take on this challenge. In the remainder of this essay, I offer three deficit-cutting ideas for such a commission to consider. Specifically, I propose to reform Social Security, adopt a carbon tax, and scale back tax expenditures. I also provide a back-of-the envelope estimate of the impact of these reforms on the federal debt in 2050. (Due to space constraints, I do not consider any changes to the federal health care programs, although a fiscal commission certainly should.) I conclude with some thoughts on a fiscal commission, including how such a body should be structured and what might maximize its chances of success.

  1. Reform Social Security Old Age and Survivors’ Insurance.

    Social Security’s Old Age and Survivors Insurance (OASI) program is funded by a 10.6 percent payroll tax on earnings up to an annual cap ($160,200 in 2023). Benefits are based on an average of a worker’s highest 35 years of OASI-taxable earnings (indexed for economy-wide wage growth) below this cap. A progressive formula is applied to this average, producing the monthly benefit that a worker will receive if they claim Social Security at their full retirement age (which has ranged from 65 for those born in 1937 and earlier to 67 for those born in 1960 or later).

    a. Switch to a Flat Benefit

    OASI benefit cuts are most likely to be politically feasible if they are concentrated among higher earners — an approach that has been favored by some Republicans. The Social Security benefit formula is already progressive: although workers with higher career-average earnings receive larger monthly benefits, benefits rise less than proportionally as earnings rise. Thus, higher earners receive a smaller monthly benefit as a percent of their earnings. The most straightforward way to reduce benefits for higher earners is to make the existing formula even more progressive.2 In fact, some Social Security analysts (including me) have advocated increasing progressivity to the point of paying a flat benefit.

    There two reasonable ways to design a flat benefit. One approach is to provide a benefit that is completely independent of a beneficiary’s work and earnings history. New Zealand currently has such a system. The New Zealand Superannuation is paid to anyone 65 and older who meets a residency requirement. This approach can guarantee that nobody will retire into poverty. However, it is likely to incentivize early retirement to a greater degree than the current U.S. system. Under the current U.S. benefit formula, extending one’s career by a year often increases benefits,3 which partially offsets the work disincentive of the payroll tax. This offsetting work incentive disappears with a benefit that is independent of one’s career length.

    An alternative approach is to create a flat benefit that is independent of career-average earnings but depends on career length. The United Kingdom currently has such a system. The new State Pension offers a maximum flat benefit of around £10,600 ($12,880 as of October 21, 2023) per year to those with 35 qualifying years of work (at a minimum level of earnings). This amount is prorated for shorter careers. To ensure that everyone has an opportunity to earn the maximum benefit, the system provides credits for periods in which individuals were prevented from working by unemployment, caregiving, disability, and certain other situations. A U.K.-style flat benefit creates less of an early retirement incentive than a New Zealand-style flat benefit, although it does not guarantee a poverty-line income.

    b. Raise the Full Retirement Age

    In addition to implementing a flat benefit, policy makers should increase the full retirement age and index it to life expectancy. To be clear, that change amounts to an across-the-board benefit cut. However, it may be politically palatable because of its framing as a response to increasing life expectancy. If policy makers are concerned about growing mortality differentials across income groups, the full retirement age could be tied to a measure of lifetime income.

    c. Increase the Payroll Tax

    On the revenue side, there are two reasonable ways to increase payroll taxes. First, the $160,200 payroll tax cap could be removed. Under current law, earnings above the cap are untaxed because those earnings, unlike earnings below the cap, are not counted in the benefit formula. If benefits are independent of career-average earnings (as proposed above), however, the cap’s rationale disappears. The cap could therefore be removed, and the payroll tax applied to all earnings — a measure that has been advocated by some on the left. Second, the payroll tax rate could be increased, raising payroll taxes across the board.

    To be sure, these tax increases will disincentivize work — an outcome I’d prefer to avoid. However, a realistic political compromise on Social Security will need to include both tax increases and benefit cuts.

  2. Adopt a Carbon Tax.

    As part of a compromise to reduce the fiscal imbalance, taxes should be increased in a way that minimizes harm to the economy. One way to achieve this goal is to tax activities that create negative externalities (spillover harms to bystanders).

    Carbon emissions create a negative externality by contributing to climate change. Policy makers have generally addressed this externality through regulation, including fuel and energy efficiency standards. They have also subsidized investments in renewable energy and energy efficiency. Compared to these policies, most economists believe that a carbon tax can reduce carbon emissions with less harm to the economy. Unlike targeted regulations and subsidies, a carbon tax puts a price on carbon and then allows individuals and businesses — who are in the best position to know how changes in consumption and production affect them — to choose how they wish to reduce their emissions and resulting tax burdens. Emissions reduction could occur through conservation, green energy, or other means.

    Many policy makers — especially Democrats — have endorsed carbon pricing. To make a carbon tax more appealing to Republicans who prefer small government, it should be paired with a rollback of regulations and green-energy subsidies.

  3. Broaden the Tax Base.

    Another way to increase revenue with minimum harm to the economy is to broaden the tax base by capping or eliminating tax expenditures, which provide tax breaks that are targeted towards specific activities. Because a tax expenditure increases the after-tax incomes of those engaging in the targeted activity, while increasing the deficit, it is equivalent to a spending program that subsidizes that activity. For example, by increasing the after-tax incomes of those who purchase electric cars, the tax credit for clean vehicles effectively subsidizes these purchases.

    I propose eliminating or capping three large tax expenditures, all of which distort economic decisions and disproportionately benefit higher income individuals.4

    First, the tax exclusion for employer-sponsored health insurance should be eliminated or capped. When workers are compensated through health insurance, they do not pay the income and payroll taxes that would apply if they were compensated through wages. This tax expenditure therefore incentivizes employers and employees to avoid tax by substituting health insurance for wages. The resulting generous health insurance plans increase the demand for health care and drive up health care costs.

    Second, the mortgage interest deduction should be capped or eliminated. This deduction contributes to a tax system that favors owner-occupied housing over other kinds of investment.

    Finally, the deduction for state and local taxes should be fully eliminated.5 This deduction artificially reduces the cost of public services provided by state and local governments.

  4. Impact on Fiscal Imbalance.

    To obtain a back-of-the-envelope estimate of the impact these reforms would have on the federal debt, I used the Committee for a Responsible Federal Budget’s “Debt Fixer” tool. The tool tells us that, under current law, the debt is projected to reach 169 percent of annual GDP in 2050.

    Starting from that baseline, I successively introduced the policies proposed in this essay. If I could not find an exact match for a proposal, I chose the closest alternative. For example, the Debt Fixer does not offer an option to uncap the payroll tax or to index the full retirement age to life expectancy. However, I chose the closest available options — to impose the payroll tax on earnings above $250,000, and to raise the full retirement age to 70. I was also restricted to the Debt Fixer’s assumptions about how quickly these policies are phased in; making changes to those schedules would no doubt alter the estimates. The results of this exercise are shown in the table below.

    Policy Debt in 2050
    (Percent of annual GDP)
    Baseline 169
    (1) Flat Social Security Benefit (150 percent of poverty line) 159
    (2) Raise Full Retirement Age to 70 154
    (3) Apply Payroll Tax to Earnings Above $250,000 143
    (4) Increase Payroll Tax Rate by 1 Percentage Point 137
    (5) Impose Carbon Tax of $25 / Metric Ton of CO2 131
    (6) Eliminate Mortgage Interest Deduction 128
    (7) Eliminate State and Local Tax Deduction 116
    (8) Cap Health Insurance Exclusion 109

    In combination, these policies would reduce the federal debt to 109 percent of annual GDP in 2050. Although beyond the scope of this essay, additional debt reduction could be achieved through reforms to the federal health care programs.

  5. Further Thoughts on a Fiscal Commission.

    While I support the reforms I’ve proposed in this essay, I would be open to a wide range of compromises to reduce the federal fiscal imbalance. That’s an attitude policy makers and citizens need to adopt if we are to have any hope of tackling the challenge ahead. A bipartisan fiscal commission would provide a means to hash out these kinds of compromises.

    Similar bipartisan bodies have, in the past, come up with sensible recommendations on Social Security reform, tax reform, and overall debt reduction. To maximize the chances of success, members of a fiscal commission should include policy makers, experts, and ordinary citizens. These members should reflect a genuinely diverse range of values, backgrounds, and interests. Commission members (and policy makers more broadly) should commit to putting forth their own debt reduction plans — ideally supported by at least one member of the other political party — if they disagree with the body’s final recommendations.

    A fiscal commission is most likely to succeed if the broader public is involved in its process. To that end, I offer the following suggestion: either the commission or a polling organization should conduct — and share results and raw data from — surveys designed to get respondents to make tradeoffs. Typical opinion polls focus on a subset of issues and do not impose a budget constraint on respondents. However, in 2012, three researchers — Siona Listokin, Yair Listokin, and Samson Mesele — conducted a survey that required respondents to choose a set of policies to achieve a specific deficit reduction target. In their first pass through the survey, most respondents supported only raising taxes on high earners and cutting discretionary spending. However, upon realizing that their initial choices fell short of the required deficit reduction, majorities eventually opted to eliminate the mortgage interest and state and local tax deductions, as well as to introduce new national taxes on carbon and retail sales. This type of survey could inform the commission about people’s preferences and facilitate the national conversation on debt reduction.

    As a society, we’ve spent much of the past century opting for more of many things, ranging from Social Security to health programs to tax cuts. The time has come to decide what we want less of. Let’s be fair to future generations and make these tough choices without delay.

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1 I thank Andrew Biggs, Russ Levsen, Slavi Slavov, and Alan Viard for helpful comments.

2 While there are other ways to reduce benefits for higher earners, Alan Viard and I have explained why any such reductions should be based on lifetime, rather than current, income. .

3 However, the increase in benefits may be small or zero for those who have worked for 35 or more years..

4 A fiscal commission could also consider reducing other major tax expenditures such as preferential rates on capital gains, the tax exclusion for pensions, and the charitable contribution deduction. I have not included them here because they are less clearly harmful to the economy.

5 Tax Cuts and Jobs Act of 2017 capped this deduction at $10,000.

About the Author

Sita Nataraj 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.

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