Today’s Major Domestic Challenges
The principles described in the previous section could be applied to the challenges specific to any point in history. Today – and with respect to this proposal – they are aimed at health care (including the Federal Government’s medical entitlements), retirement security, taxes, and job training.
To address these areas properly, the discussion below summarizes the particular nature of the problems in each. The text also examines the broader questions of government spending in general and America’s challenges in the global marketplace of the 21st century, and concludes with a discussion of why it is necessary to take action now.
THE STATE OF HEALTH CARE TODAY
The rising cost of health care in the United States is the fastest-growing burden on families, businesses, governments, and the economy. In 2007, the U.S. spent an estimated $2.1 trillion to provide, administer, and finance health care – nearly twice the amount per capita spent by any other industrialized nation in the world. Moreover, the rapid growth of health care costs – about 7 percent per year – is eroding paychecks for millions of Americans; and skyrocketing insurance costs are overburdening businesses across the U.S., and in 2010, 50 million people – 19 percent of the non-elderly population – will lack access to health insurance at some time during the year.
Even with public health programs such as Medicare and Medicaid, families and individuals face increasingly limited access to care and coverage. State budgets are unable to keep pace with the financial resources these programs demand while the number of physicians and health care practitioners choosing to participate are steadily declining. Failed Federal policies and inadequate reimbursement levels are threatening the existence of these programs for future generations.
The personal realities of this crisis also have a distressing effect on U.S. economic stability. The Federal Government devotes 21.7 percent of its budget to the two major health entitlements, Medicare and Medicaid, which is more than national defense (17.8 percent, including war costs). Overall health care costs are absorbing 15.2 percent of national gross domestic product [GDP]. If the status quo continues, health care costs will consume 20 percent of GDP by 2016.
Rising health care spending also is the major contributor to the unsustainable projected increases in the Federal Government’s two major health programs, Medicare and Medicaid, which are the main contributors to projected chronic Federal budget deficits. The effect of this spending growth is even greater than that of lengthening life-spans and the forthcoming retirement of the baby boomers. “Long-term deficits are driven not only by the aging of the population,” says Dr. Isabel V. Sawhill, senior fellow at the Brookings Institution. “[T]hey are much more driven by increasing health care costs per capita . . . The demographics play a role. But if you look at the numbers carefully you will see that the problem has been health care spending per capita that has been growing 2 to 3 percent faster than per-capita incomes or per-capita GDP.” During the period 1999 through 2008, the monthly premium for seniors who participate in Medicare has risen at nearly the same rate as those in private insurance, from $45.50 to $96.40.
Furthermore, the government health programs rely on the infrastructure of private health care. As noted by the Congressional Budget Office [CBO]: “[M]ost [public] services are furnished by private providers. For example, Medicare and Medicaid beneficiaries receive most of their care from physicians, hospitals, and other providers that deliver services to the general population.” Therefore, inadequacies or inefficiencies in private health care services affect Medicare and Medicaid as well. It is another reason why correcting problems in the government health entitlements also requires addressing inefficiencies in the market.
But if rising private health costs drive the growth of Medicare and Medicaid spending, the converse also is true: Medicare and Medicaid themselves contribute in their own way to medical inflation. These two programs account for roughly 37 percent of all health care spending nationally (including the State share of Medicaid), according to the most recent figures from CBO. Another 10 percent comes from other public programs, including those of State and local health departments, the Department of Veterans Affairs, and workers’ compensation. Such large infusions of government funds inevitably stoke rising medical costs.
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Also noteworthy is that real per-capita growth in Medicare and Medicaid spending has outpaced that occurring in the market (see Table 4). This demonstrates that government spending tends to be less efficient than spending in the market. Hence, overall medical costs cannot be tamed without also addressing the structure of the Federal health entitlements.
Failings of Recent Health Care Proposals
The overhaul legislation considered in Congress during the past year failed to correct the fundamental problem in U.S. health care: the distortions of the health care market created by ever-deepening government intrusion. Instead, it sought to expand the government’s role, impose further regulation, as well as job-killing taxes on small businesses. It failed to bend down the medical “cost curve,” meaning more rapid cost increases, resulting in government rationing and price setting. As recently summarized about the legislation under consideration:
[I]ts principles are a reprise of previous reforms – addressing access to health care by expanding government aid to those without adequate insurance, while attempting to control rising costs through centrally administered initiatives. Some of the ideas now on the table may well be sensible in the context of our current system. But fundamentally, the “comprehensive” reform being contemplated merely cements in place the current system – insurance-based, employment-centered, administratively complex. It addresses the underlying causes of our health-care crisis only obliquely, if at all; indeed, by extending the current system to more people, it will likely increase the ultimate cost of true reform.
It also sought to establish a huge new government entitlement, and aimed to drive private insurance out of the market. The proposals were rooted in an ideological view that always sees government as the necessary solution to any significant problem.
The Real Sources of America’s Health Care Problem
The problems in American health care have been caused not by a failure of the health care market, but mainly by distortions imposed on the market from several directions; and the most significant of these are Federal tax subsidies and programs that have created a third-party payment system, which insulates consumers from prices and market forces. As one description puts it:
All of the actors in health care – from doctors to insurers to pharmaceutical companies – work in a heavily regulated, massively subsidized industry full of structural distortions. They all want to serve patients well. But they also behave rationally in response to the economic incentives those distortions create. Accidentally, but relentlessly, America has built a health-care system with incentives that inexorably generate terrible and perverse results. Incentives that emphasize health care over any other aspect of health and well-being. That emphasize treatment over prevention. That disguise true costs. That favor complexity, and discourage transparent competition based on price or quality. That result in a generational pyramid scheme rather than sustainable financing. And that – most important – remove consumers from our irreplaceable role as the ultimate ensurer of value.
At the heart of the problem is the Federal tax exclusion for employer-provided health coverage. This policy undermines the health care market by hiding the true cost of insurance from those covered by it, and contributing to more expensive care and more costly insurance. As C. Eugene Steuerle of the Urban Institute describes it:
The exclusion is open-ended. The more insurance we buy, the larger the amount of income we get to exclude from tax and the more the government subsidizes us. The exclusion favors most those of us who have the most generous health insurance policies. Moreover, because more insurance means that we face even less of the cost of what we buy – we and our doctors now bargain over what the plan, not us, will pay – we demand more care and more expensive care. . . . Additionally, the increased demand for health care tends to encourage growth in the health care sector in a less than optimal way. For instance, it tends to encourage suppliers of medical care to increase the quantity of what we get, with less incentive to increase quality.
One reflection of the problem is the dramatic decline in private and personal out-of-pocket spending for health care – even for routine procedures – while government spending has steadily grown:
From 1975 to 2007, the share of total health care spending that was financed privately shrank slightly, dropping from 59 percent to 54 percent, while the share that was financed publicly expanded correspondingly, increasing from 41 percent to 46 percent. During that period, consumers’ out-of-pocket payments fell from 31 percent of total expenditures to 13 percent, and payments by private insurers rose from 25 percent to 37 percent.
The combination has encouraged overuse of health care services. “Because so many Americans rely on an insurance policy or a government program to pay their health care bills, the internal governors that temper the rest of their purchases are turned off,” writes Investors Business Daily. “When a visit to the doctor’s office or a diagnostic test costs them a mere $10 or $20 co-payment out of pocket – or there is no charge at all – cost has little impact on their decision to see a doctor.”
The tax policy that contributed to all this came about not by plan, but as an accident of historical events. During the Second World War, when the Federal Government imposed wage and price controls, employers sought to attract workers from a tight labor pool by offering modest health coverage, and excluding the costs from wages. When these employers sought endorsement of the practice from the Internal Revenue Service [IRS], the IRS approved. After the war, when the IRS tried to rescind this decision, Congress wrote it into law. The exclusion, which this year totals an estimated $155 billion, has made employer-provided coverage the most common form of health insurance.
Although the employer-based tax benefit has been important to the provision of health care, it has evolved into an expensive, inflexible, and unfair subsidy. It also contributes to the insecurities felt by those who have employer-based health insurance, because they fear sacrificing coverage if they lose or change jobs.
The tax provision also has failed to encourage the expansion of health coverage. Since 2000, the percentage of businesses offering health benefits has fallen 69 percent – mainly due to the continued rise in insurance costs. Rising costs also make health coverage unaffordable to many small businesses, self-employed persons, and low-income persons. Indeed, the current tax policy actually increases the number of the uninsured:
As the increased amount of money spent on the exclusion effectively increases the average cost of health care and of health care insurance, the greater the number of individuals in the economy who forego purchasing private health insurance. Not only are low-income people more likely to avoid purchasing health insurance, but many middle-class people and people between jobs decide to take a chance and save the amount of the health insurance premium. Employers, beset by demands from their workers for cash wages, are also more likely to drop health insurance. At times, this happens directly, but more often than not it works its way into the system indirectly. The company with expensive health care insurance reduces the number of its employees, or, if growing, tries to outsource to groups for whom it does not have to pay for insurance. New companies without health insurance displace older ones that carry health insurance.
The third-party insurance arrangement also sharply reduces the options of health coverage packages available. Americans are limited in their choices of health insurance plans based on what their employers can afford – if a health plan is even offered at all. Consequently, Americans are deprived of a diverse health insurance market in which they can find affordable coverage options truly suited to their needs.
Adding to the problem is the lack of transparency in health care price and quality data, which further prevents patients from making the kinds of judgments they do in purchasing other services. For example, in the Milwaukee, WI area a heart bypass operation costs $100,000 at one hospital, while the same procedure costs $48,000 at another. Yet patients, and sometimes even doctors, are unaware of this difference.
Obviously, nearly all patients would rely on third-party coverage for such an event; it is the kind of episode for which consumers most need insurance. But because prices are opaque, patients have no incentive even to consider and compare them – let alone variations in the quality of services – in choosing where to undergo such procedures.
In fiscal year 2009, 67.8 million people were enrolled in Medicaid at some time during the year. Some 34 million of these beneficiaries were children, and 18 million were adults in families with dependent children. The program has provided Americans of limited means access to health care they could not have obtained otherwise.
But Medicaid spending, too, is spiraling out of control: it is growing at a rate of about
7.5 percent per year, and the combined Federal and State costs to run this program in fiscal year 2008 was $353 billion. As a share of total economic resources, Medicaid spending is projected to increase from 3 percent of GDP today to 5 percent by 2035, and 15 percent by 2080. State budgets are overwhelmed with these costs and Federal officials are struggling to meet the growing fiscal needs required to keep this program running. States are trying to shift their Medicaid costs to the Federal Government.
At the same time, Medicaid has fostered a two-tiered hierarchy within the health care marketplace that stigmatizes Medicaid enrollees. Providers are paid based on bureaucratically determined formulas that do not reflect the market. As a result, fewer and fewer providers are willing to participate in the program, meaning longer lines for beneficiaries, fewer operational clinics, and insufficient care.
Patients suffer as a result. With administrators looking to control costs and providers refusing to participate in a system that severely under-reimburses their services, Medicaid beneficiaries ultimately are left navigating an increasingly complex system for even the most basic of procedures.
When President Johnson signed Medicare into law more than 40 years ago, he cited a principal goal of the program that cannot be achieved under its current spending path: “No longer will young families see their own incomes, and their own hopes, eaten away simply because they are carrying out deep moral obligations to their parents, and to their uncles, and their aunts.” Absent reform, the program will end up delivering exactly what it was created to avoid: it will consume the prosperity of today’s younger generation to finance an unsustainable path of spending.
Medicare was created with the worthy mission of providing health coverage for America’s retirees, and for many it has done so. But the program suffers from unsustainably rapid spending increases that continue to drain economic and fiscal resources on its way to insolvency. In short, the program, as currently structured, cannot keep its promises to future generations.
The cost of Medicare has always been higher than expected. For example, in 1965 it was estimated that benefit payments for Medicare’s Hospital Insurance [HI] program would total $8.8 billion in 1990. The actual spending was $65.7 billion (see Table 5). Today, Medicare outlays are growing at a rate of 7.2 percent per year, more than twice the average rate of current real GDP growth. Over the next 25 years, Medicare spending as a share of the economy will nearly triple – from 3 percent of GDP today to 8 percent by 2035. By 2080, it will have grown to 15 percent of GDP.
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To rescue Medicare from financial collapse requires transforming the program to make it financially sustainable, and more consistent with the character of medical care in the
In 1935, the year Social Security was enacted, there were about 42 working-age Americans for each retiree. The average life expectancy for men in America was 60 years; for women it was 64. With these demographics, it was easy for the program to generate sufficient revenue to meet its promises to those over 65. The initial Federal Insurance Contributions Act [FICA] tax rate was 1 percent each for workers and employers, up to $3,000 of income.
But even President Roosevelt knew this could not last. “Roosevelt himself saw that while the program’s revenues might cover its costs now, the numbers from the actuaries suggested that there would not be enough money for old-age pensions for future generations.”
President Roosevelt was right; and today, the challenge facing Social Security is more inexorable than at any time in the past – including its near-collapse of 1983. What’s more, the risk to Social Security is nearer at hand than most acknowledge. Due to the recession, Social Security surpluses will disappear in 2010 and 2011, with small and declining surpluses after that. By 2016, the program will hit a permanent “negative cash flow” – when annual benefit payments exceed annual payroll tax revenue – less than a decade from now. (See Figure 5.)
The cash flow trend is significant for the following reasons. Since the 1983 Social Security reform, the program’s trust fund has run substantial cash surpluses: it has been collecting significantly more in dedicated tax revenue than it needed to pay annual benefits. These cash surpluses were “borrowed” by the general fund to finance other government programs, and were replaced by government bonds that promised the cash would be returned when needed, with interest.
For the next 2 years, and starting permanently in 2016, Social Security will have to begin redeeming the trust fund bonds that have accumulated in recent decades. This will lead to one of four options, or some combination: 1) other government programs will have to be squeezed to finance Social Security; 2) taxes will have to rise sharply to cover benefits; 3) benefits will have to be cut; or 4) the government will have to run large and chronic deficits to pay Social Security benefits. By 2037, the Social Security Trust Fund will be exhausted and the program will be unable to pay all its promised benefits. Without reform, benefits will have to be cut by 24 percent, or payroll taxes raised by 31 percent.
The latter would tear the social fabric of the program itself. “Hiking payroll taxes is neither an economically sound nor a generationally equitable option.” says Robert L. Bixby, Executive Director of the Concord Coalition. “The burden will fall most heavily on lower- and middle-income workers and on future generations. Younger Americans in particular will be skeptical of any plan that purports to improve their retirement security by increasing their tax burden and by further lowering the return on their contributions.”
As is well known, a major part of the problem is demographic. The first members of the baby-boom generation – those born between 1946 and 1964 – are now eligible for early retirement. At the same time, life expectancies now average 75 years for men and
80 years for women – and these too are expected to lengthen. These factors result in a permanent, long-term shift in which the percentage of the U.S. population over 65 will grow from 12 percent in 2007 to 19 percent by 2030, and the share of those who are 20 years old to 64 years old is projected to decline from 60 percent to 56 percent. The effect on Social Security translate as follows: today there are only 3.3 workers for each Social Security beneficiary, and that number is projected to fall to 2.2 by 2030, and continue dropping thereafter. These figures compare with the 42 workers per Social Security-eligible retiree in 1935, and 16 workers per beneficiary in 1950.
This demographic realignment is not a temporary phenomenon, associated solely with the retirement of the baby boomers, but a long-lasting shift; and it is more than a problem just for Social Security or Federal Government spending: it poses a challenge to the economy to generate sufficient resources to support the income and health needs of a growing population of retirees. Long-term economic growth depends on two factors: employment growth and productivity growth. But employment growth is tied to an expanding labor force, which under current projections is expected to decline (see Figure 11). Additionally, there has been a demographic shift to a lower retirement age. In 1945, the average age of retirement was 69.6 years; in 2007, it was 63.6 years. As the nonworking-age population grows, there will be lower labor force participation and therefore lower per-capita output. The economy will need some means of boosting labor-force growth, or compensating for the lack of it, to support future retirees.
But even if the prospects for economic growth could be vastly improved – by enhancing productivity and wages, for example – it would not ease the problem with Social Security, because the program’s benefits are partly indexed to such economic factors. “[B]ecause of the structure of Social Security, that growth in productivity and wages automatically translates into higher future benefits, offsetting a significant portion of the fiscal gains from a larger economy,” says a recent paper by the Brookings-Heritage Fiscal Seminar. “In short, if the status quo continues and entitlement programs are not reformed, there is no feasible growth rate of the economy that will produce a sustainable budget path.”
The combination of demographic and benefit patterns will drive total Social Security spending to unprecedented levels. CBO estimates that: “[U]nless changes are made to Social Security, spending for the program will rise from 4.3 percent of GDP in fiscal year 2008 to 6.0 percent by 2035. Spending for Social Security will dip slightly as members of the large baby-boom generation die, but it will then resume its upward course because of increasing longevity, reaching 6.1 percent of GDP in 2080.”
There are other reasons to reform Social Security.
First, the current program is not a good deal for workers. For the average individual currently paying in to the system, the real rate of return from Social Security is between
1 percent and 2 percent. For some individuals, particularly younger ones, the rate of return is expected to be negative. By contrast, the average rate of return from the stock market since 1926 has been at least 7 percent, even taking into account significant stock market decline, including that of 2008.
Second, the current system is unfair to minorities. The projected shorter life expectancies of minorities significantly reduces their benefits compared with Caucasians. For example, a 30-year old white man with average earnings and average life expectancy will receive nearly $70,000 more in lifetime Social Security benefits than an African American man with the same characteristics.
Third, today’s workers have no legal rights to the taxes they have paid into Social Security. According to the Supreme Court in Flemming v. Nestor, workers and their families have no legal claim on the payments that they make into the U.S. Treasury. As a result, Congress is free to change these benefits at any time.
Finally, Social Security benefits are not inheritable. A worker may pay into the Social Security system for a lifetime and have nothing to pass on to heirs – in stark contrast with other types of retirement funds that are inheritable.
While government spending drives the need to tax (or borrow), the Federal tax code as currently written will become a kind of “revenue machine,” claiming ever-growing shares of individuals’ income and the economy’s resources. Under current-law projections by CBO, tax revenue is scheduled to approach an unprecedented one-fourth of GDP by mid-century. To put this in context, Federal revenue has exceeded 20 percent of GDP only once since World War II, reaching 20.9 percent of GDP in 2000.
The start of this reckoning is near at hand. As Professor Michael J. Graetz of Yale Law School has put it:
[T]he scheduled expiration in 2010 of large tax cuts enacted in 2001 and 2003 builds a large tax increase into the current tax law. If Congress fails to act, income tax rates will rise, as will tax rates on capital gains and dividends, and people will lose many current benefits, including credits for children and relief from marriage penalties. Under current law, the estate tax exemption rises to $3.5 million next year with a 45-percent top rate, the tax is repealed in 2010, and in 2011 the tax comes back with a $1 million exemption and a 55 percent top rate. . . . And, as this committee knows well, the alternative minimum tax [AMT] is currently structured in a way to catch millions more Americans and must be fixed or repealed.
The AMT is in fact a perfect example of the faulty assumptions in Federal tax law. When originally enacted, the tax was designed to prevent a small number of high-income individuals from avoiding taxes by manipulating the complex rules of an already flawed tax code. But because Congress failed to index the AMT for inflation, the tax threatens, every year, to ensnare millions of middle-income families. CBO estimates that, if left unchanged, the AMT would hit about two-thirds of American taxpayers by 2050. Nearly everyone agrees this scheduled AMT expansion is illegitimate; and though each year Congress has tried to “patch” the AMT, its expected revenue increase is built into current law projections, creating a presumption of higher revenue that masks the magnitude of budget deficits that the current path of government spending will create.
In addition, individual income taxes are needlessly complex, riddled with special provisions that manipulate individuals taxpayers’ behavior and reduce economic efficiency. Professor Daniel N. Shaviro of the New York University School of Law has testified: “[T]he tax system needlessly aggravates and complicates the lives of lower and middle income taxpayers. Congress can and should address this, by making filing and compliance less painful, even insofar as taxes paid by such individuals remain approximately constant.”
When the U.S. tax code was established in 1913, it contained roughly 400 pages of laws and regulations. Since then, the Federal tax code has grown exponentially and stands at more than 70,000 pages today. Since 2001 alone, there have been more than 3,250 changes to the code, or more than one per day. Many of the major changes over the years have involved carving out special preferences, exclusions, or deductions for various activities or groups. The special tax breaks and preferences now add up to more than $875 billion per year. These layers of carve-outs and changes have made the code unfair, inefficient, and wildly complex. The Treasury Department’s guide book on tax regulations, issued to help users interpret the meaning of the code, comprises six full volumes and sums to nearly 12,000 pages.
The National Taxpayer Advocate at the Internal Revenue Service [IRS], Nina E. Olson, calls the complexity of the code “the most serious problem facing taxpayers” and says the only meaningful solution is a drastic simplification. The code is so complex that 60 percent of Americans have to use paid tax preparers to complete their forms correctly. Another 20 percent rely on tax preparation software, such as Turbo Tax, to complete their forms. Even the IRS commissioner admitted in a recent interview that he relies on a tax professional to complete his returns, in part because of the code’s complexity.
The average tax preparation fee for a standard itemized 1040 Form and an accompanying State tax return is just over $200, while small businesses pay between $500 and $700 for help with their forms, according to the National Society of Accountants. The total cost of complying with the individual and corporate income tax (gathering the requisite information, preparing the forms, etc.) amounts to roughly $200 billion per year, or 14 percent of all income tax receipts collected. If tax compliance were an actual industry engaged in productive economic activity, instead of a metric of wasted time, energy, and money, it would be one of the largest in the U.S.
Taxpayers who are unwilling or unable to pay for outside help with their taxes must turn to an IRS whose level of service has been deemed “unacceptable” by the National Taxpayer Advocate. According to the Advocate’s latest report to Congress, the IRS has a self-imposed goal of answering only about 70 percent of the phone calls placed through its toll-free help line this year The IRS says that its tax advisors have a high accuracy rating in terms of their tax advice, but that is small consolation for the portion of callers who cannot reach anyone. In fact, the share of callers who 1) connect to an IRS tax advisor (after waiting an average of 12 minutes) and 2) get a correct answer to their question is just 65 percent.
In the realm of tax policy, Congress sometimes focuses its efforts on improving tax compliance and trying to narrow the “tax gap” (i.e. the difference between what is owed in taxes and what is actually paid). Estimates suggest that the net tax gap is roughly $290 billion per year. But the tax gap is not the key underlying problem. It is merely a symptom of a complex and broken tax code. The most direct way to reduce this complexity, thereby improving tax compliance and easing the administrative burdens of the system, is to dramatically simplify the tax code.
Taxes impose two types of economic costs: the direct cost of the taxes themselves, and the indirect costs of the changes in behavior that result. For instance, taxes can affect the incentive to work. When marginal income tax rates are high, they penalize productivity, as people keep less of their earnings. This reduces the potential to maximize labor force participation.
The U.S. tax system also discourages capital investment, a necessary component of long-term growth and rising living standards, by essentially taxing savings twice. Individuals pay income taxes on their wages and salaries and, if they choose to save these funds, pay another round of taxes when they reap investment gains. This arrangement encourages individuals to consume their wages and salaries immediately rather than saving and investing them.
The double-taxation of corporate profits offers another example of the disincentive effects on investment of the current U.S. tax code. Corporate profits are taxed once at the business level and once again at the individual level, when the profits are distributed as dividends or capital gains. This double taxation boosts the cost of capital and leads to lower investment in the corporate sector.
In short, tax policy is a key element that will influence the two components of long-term economic growth: investment and labor force participation.
Here are several other factors that come into play in tax policy.
Tax Rates. The importance of taxes to competitiveness is echoed by a recent study released by the U.S. Treasury. Treasury finds that business location and investment decisions are becoming more sensitive to country tax rates as global integration increases. Foreign investment is important to an economy because it is a key source of innovation and jobs. In response, many countries have been lowering business taxes. But the U.S. risks falling behind: it already has the second highest corporate income tax in the Organisation of Economic Cooperation and Development [OECD] (see Figure 12). The U.S. may soon have the highest rate, as Japan and France have signaled their intention to lower their corporate income tax rates, joining the trend set by many other industrialized countries in recent years. As described in recent testimony by Robert J. Carroll, Vice President for Economic Policy at the Tax Foundation:
By standing still, the United States can expect to see reduced inflows of foreign capital and investment because the United States will be a less attractive place in which to invest, innovate and grow. U.S. firms will face a higher cost of capital than foreign firms, making it more difficult to compete in foreign markets. In the near-term, this would translate into slower economic growth, a slower advance in labor productivity, and less employment. The industries that are being hurt the most are those that manufacture or buy capital-intensive products.
Although corporate taxes may be a politically popular revenue source, they actually create perverse incentives that impede economic growth, and therefore penalize workers and consumers.
Economists are unanimous . . . that the corporate tax is a bad one. It creates incentives for investing in noncorporate businesses and housing instead of corporations, and it induces many distortions in corporate finance. For example, since interest but not dividends are deductible and thereby not subject to the corporate tax, the tax creates a bias in favor of debt over equity finance. The combination of individual and corporate income taxes also has created an advantage for corporations to repurchase shares rather than paying dividends. The invention and deployment of innovative financial products has added new distortions as companies structure their financial transactions to achieve income tax advantages. The internationalization of businesses, along with the greater mobility of capital, has made collecting corporate income taxes much more difficult. Companies, for example, now routinely manipulate their corporate structures, finances and inter-company prices to take advantage of lower corporate tax rates in other countries. These are just some of the reasons that economists hate a tax the public seems to love.
Elevated corporate tax rates hinder American competitiveness by making the U.S. a less desirable destination for investment and jobs. By deterring potential investment, the tax restrains economic growth and job creation. The U.S. tax rate differential with other countries also fosters a variety of complicated multinational corporate behaviors intended to avoid the tax – profit shifting, corporate inversions, and transfer pricing – which have the effect of moving the tax base offshore, costing jobs and decreasing corporate revenue.
U.S. tax policies also create an unlevel playing field in the international market. The overwhelming majority of America’s competitors rely to some degree on consumption-based taxes, which, according to World Trade Organization rules, can legally be rebated on products leaving a country for export and imposed on products entering that country. The United States happens to be the only major industrialized country in the world that does not use a similar tax system and therefore cannot engage in the same practice. Hence, when Milwaukee-based Harley-Davidson makes a motorcycle it plans to sell overseas (to Japan, for example), the motorcycle is taxed once in the U.S. before being shipped, and once again when it reaches the Japanese border. In contrast, when a Honda motorcycle is shipped from Japan to the U.S., the Japanese government lifts the tax on the motorcycle before export, and it arrives in the U.S. essentially tax-free. This combination of tax policies gives foreign producers a clear cost advantage and hampers the ability of U.S. manufacturers, such as Harley-Davidson, to compete in the global market.
Tax Certainty and Consistency. Equally important over time is maintaining a consistent and predictable tax policy. Only in such an environment can businesses effectively plan the long-term investments needed to sustain economic growth. In addition, foreigners will be unlikely to invest in the U.S. if they conclude that U.S. tax laws are likely to keep changing, or rates to keep rising.
Flexibility and Adaptability. In an ever-changing international marketplace, economic flexibility and adaptability are increasingly important. The U.S. economy has been successful historically due in part to its flexible and efficient capital markets, which direct investment resources to their most productive uses – seeking out new and profitable ventures and redeploying investment from old industries into new fields. High tax rates on investment and capital can impair this innovation dynamic and can harm U.S. economic competitiveness.
A CHANGING ENVIRONMENT FOR WORKERS
As technological advancements and global competition churn through old jobs and create new and better ones, more workers from time to time will have to obtain additional skills to meet the changing demands of the modern job market. That is why it is vital to ensure Federal job training programs are effectively serving workers and continually improving. Unfortunately, training opportunities funded by the current system not only can be difficult to access, they often fail to benefit trainees, or provide only modest benefits.
The greatest challenges with the current system are lack of accountability and incentives to maximize effectiveness. There are 49 Federal job training programs, administered by eight different agencies. Each program has its own unique set of performance goals and requirements that States must follow. This makes it extremely difficult for administrators to avoid duplication, to be efficient with funding streams, and to tailor training to local needs. As summarized recently by Virginia Senator Warner, former Governor of the Commonwealth:
I can again recall as Governor one of the most frustrating areas that I found was how we could try to right-size and rationalize government training. I found at a State level we had a variety of different programs about employment and training. They were all siloed. And too often, as we tried to rationalize that approach, we found that the funding streams all led to Washington, and there was actually no collaboration at all..
Differing reporting requirements also make it virtually impossible to compare program performance and determine if the program is actually instilling trainees with the skills they need to achieve self-sufficiency. Finally, there exists little incentive to try new approaches and improve outcomes.
The problems of health care, retirement security, taxes, and job training all have broader effects – on the government’s fiscal condition, and on America’s ability to compete, and to lead, in the global marketplace.
One of the clearest indications of the government’s impact on the Nation and the economy is government spending, because – whether it is financed through taxes or borrowing – spending reflects the amount of economic resources the government consumes; and those resources otherwise would be available for growth-producing activities in the private sector. In addition, taxing and borrowing occur only because government needs the resources to finance its spending (unlike a business, which raises revenue as an end in itself). In short, spending is the root cause of all government fiscal consequences.
According to CBO, government spending as a share of the economy is projected to double to more than 40 percent of gross domestic product by 2050. Raising taxes or borrowing to meet these spending needs will cripple the economy and destroy U.S. international competitiveness.
High government spending tends to crowd out more productive private sector investment, which leads to declines in productivity and lower GDP growth. Redistributive spending – the kind involved in Federal entitlement programs – also distorts the allocation of resources in the economy; and an increasing domination in the form of government intervention and spending can erode private markets. Redistributive government spending also sets up incentives to capture the benefits of government transfers and subsidies rather than engaging in productive behavior. As government grows and assumes increasing responsibility for services that could be more efficiently provided by private markets, diminishing rates of return on government spending set in. In addition, the high tax rates needed to fund government spending also depress the incentives to work, save, and invest. High tax rates dampen entrepreneurial activity and risk taking, factors that are particularly important in a modern, dynamic economy.
In short, higher tax rates discourage the forms of productive behavior that are crucial for long-term economic growth.
Figure 13 on the next page shows the general relationship between government spending and economic growth. Obviously, some government spending is necessary to foster a functioning market economy. Governments must provide for a limited set of public goods: they must build roads and other infrastructure, foster the protection of property rights, and maintain internal and external security. As the upward-sloping portion of the curve illustrates, this “core” government spending tends to foster economic growth. But when government spending increasingly exceeds these core functions, economic growth begins to suffer (i.e. countries reach the downward sloping portion of the curve). As the figure illustrates, past a certain level, more government spending and higher levels of taxation begin leading to slower rates of economic growth.
This general observation is borne out in the real world. The Joint Economic Committee has studied the relationship between the size of government and economic growth in 23 industrialized countries during 1960 through 1996. The results show, for instance, that countries with government spending in excess of 40 percent of GDP experienced less than half the rate of GDP growth, on average, than countries with leaner governments (i.e. between 25 percent and 39 percent of GDP). The committee’s econometric analysis of the international data yields a convenient rule of thumb: an increase in government spending of 10 percentage points tends to reduce a country’s annual rate of GDP growth by about 1 percentage point.
These kinds of studies show that America’s budgetary problems cannot be solved by simply increasing government and raising taxes. The economic cost of this route would be devastating.
The International Marketplace
In the 21st century, the oceans no longer separate national economies. With the deployment of broadband technology and a host of other, new technological advancements, the U.S. economy is part of an interrelated, international network. The force of competition is fierce, with the rapidly growing economies of China and India playing especially vigorous roles. Virtually no worker or industry is immune from these new competitive realities. In confronting this new economic environment, America needs a plan that not only helps workers cope with this new economic anxiety, but also wins this new international competition. In this respect, lessons from past failures and successes are instructive.
In the 19th and 20th centuries, America came into a league of its own in terms of rapid economic achievement, rising living standards, and international competitiveness. Several factors contributed – principally a reliance on the individual and private markets – which generated innovation and growth that laid the groundwork for increased prosperity.
Since 1995, The Heritage Foundation and The Wall Street Journal have published the Index of Economic Freedom, which tracks the economic progress of 162 nations. The results are clear: countries with relatively modestly sized governments that embrace economic and individual freedom are the wealthiest in the world. Consistently, America ranked among the top; and today, other nations are providing stiff competition to the U.S. by reforming their economic policies to emulate this economic strategy (see Table 6). In just the past year, the United States has dropped from fifth to sixth in the top ten list.
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The Federal Reserve Bank of Dallas, which has been researching the link between global competition and pubic policy, concludes that in such a world, “countries win by instituting better policies and lose by overburdening their economies with taxes, regulations, trade barriers, and policy instability.” The Dallas Fed’s research shows that the most successful countries in this era are the ones that promote faster growth, lower inflation, higher incomes, and greater economic freedom.
Unfortunately, America’s status as the world’s leading economic power is clearly threatened by the trajectory of current Federal Government fiscal policies. As a result, to support continued prosperity and rising standards of living, it is crucial for the U.S. to embrace policies that will promote its leadership in the international marketplace, and to acknowledge the increasing importance of individual freedom and private markets.