Tax Policy Center | Urban Institute and Brookings Institution

Do We Need a Value-Added Tax to Solve Our Long-Run Budget Problems?

Rudolph G. Penner

Published: June 23, 2009
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Abstract

The U.S. budget is on an unsustainable path. That is because Social Security, Medicare, and Medicaid, which together constituted almost one half of noninterest spending before the recent stimulus plan, are all growing faster than tax revenues. If these programs are not reformed, tax burdens raised, or other spending decimated, deficits and the national debt will explode. It is difficult to imagine solving the entire budget problem by slowing spending growth, because benefits would then be far below those previously promised. It is equally unlikely that tax increases could solve the whole problem because the tax burden would then be so far above any ever experienced by Americans. To the extent that tax burdens are to be increased, there are three options. Tax rates could be raised in the existing system, but that would be extremely inefficient. Tax reform might raise revenues more efficiently, but that is excruciatingly difficult politically. That leaves the possibility of a brand new tax and a VAT is a very likely candidate.


Introduction

Most people have heard that the United States faces a severe long-run budget problem. It is often called an "entitlement problem," but that is misleading. On the spending side, only three programs are to blame: Social Security, Medicare, and Medicaid. Before the recent run-up of spending related to the recession and stimulus program, the three constituted almost half of noninterest spending, and all three are growing faster than tax revenues. They are growing rapidly because a large portion of their benefits is devoted to the elderly and the elderly population is growing rapidly as a result of the aging of the baby boom and growing life expectancy. Baby boomers started receiving Social Security in 2008 and the first one will apply for Medicare in 2011.

In addition to serving a growing elderly clientele, Medicare and Medicaid face soaring health costs per beneficiary. Historically, per capita health costs have grown by somewhat more than 2 percent per year faster than incomes per capita. Over the long run, excess health cost growth presents more of a budget problem than the aging of the population, but there is an important aspect of aging that is not much discussed. The average age of the population is growing both because there are more old people and because there are relatively fewer young people. The baby boomers did not produce enough little potential taxpayers to support them well in their old age. If baby boomers had had as many children as their parents, tax revenues would be growing more rapidly and the long-run budget problem would be much less serious.

Given that the three large programs are growing considerably faster than tax revenues, the arithmetic of the long-run problem becomes pretty obvious. If the total tax burden remains constant at its 50-year average of slightly more than 18 percent of GDP and if we devote the same fraction of GDP to defense, nondefense spending, and other entitlements and if Social Security, Medicare and Medicaid are not reformed, deficits are bound to soar. Eventually, they explode because the national debt begins to rise so rapidly that the interest bill on that debt starts to dominate total spending. We begin to borrow to pay interest and we?ll end up borrowing to pay interest on the interest. At that point, total spending, the deficit and the national debt begin to go straight up (Congressional Budget Office 2007).

Analysts make such long-run projections to show that they cannot happen. Obviously, foreign and domestic public and private investors will stop buying our debt long before deficits explode. Therefore, something has to give?hopefully before there is a crisis in international capital markets. The three rapidly growing programs must be reformed; all other activities of government must be cut to the bone; or tax burdens must rise.

(End of excerpt. The entire paper is available in pdf format.)


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