Monday, July 11, 2011

Debt and Deficits

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As the President and Congress tussle over raising the government's debt limit, we have not heard anyone ask or answer two basic questions: Why does the government take on debt? What is an appropriate level of debt? These are not philosophical questions or a tug between Keynesian and supply-side economics. Rather, they are business and management questions -- questions that Congress has not answered and is woefully unprepared to answer.

While the government's debt has marched steadily higher, the major political parties have taken two extreme views: one, that growing debt shouldn't prompt programmatic changes; the other, that starving the government of revenue will control debt. But starvation has not managed debt growth and gluttony has all public finance in a precarious position. This debt, as it approaches $15 trillion and 100 percent of gross domestic product, now exceeds the annual budget fourfold and annual interest payments on the debt eat up about 10 percent of tax receipts.

So why does the government take on debt? Quite simply because expenditures exceed revenues, which results in an annual budget deficit. That's the mechanics of it but it's not good policy. The worst of it is that deficits have occurred in good economic cycles as well as bad.

Incurring debt is not -- in itself -- bad policy. But taking on debt in good economic cycles is bad policy in two aspects. First, because tax receipts rise as incomes rise with the economy, the government should run a surplus -- not a deficit -- to retire debt incurred in previous, poor economic cycles. Second, when the economy is running hot, additional debt throws more gasoline on the fire and causes the cycle to spike earlier -- and crash harder.

In bad economic cycles, incurring debt to invest in infrastructure, education, and basic scientific research takes up the slack in capacity between good economic cycles and prepares the economy for the next uptick. But cutting tax rates in a bad economy -- though it may appear to help -- tends to have the unwanted consequence of households using the tax cuts to pay down household debt rather than purchasing goods and services, thereby further cooling the economy.

And what is an appropriate level of debt to maintain? The answer is somewhat indirect given the current situation. In the long run, the sum of annual budget deficits and surpluses should equal zero. However, the government -- and we, the people -- now has $15 trillion in debt to pay off. So the long-term plan now has to emphasize surpluses because of past profligacy. And the long-term goal for the debt is zero, knowing that realizing that goal is far, far away with many economic cycles to navigate.

Throughout the debt ceiling negotiations, the only thing that's certain is uncertainty -- whether it's what goods and services the government will purchase or what tax rates individuals and businesses will pay. And because the tax code is so convoluted and contorted, no business or individual can know with certainty what their annual tax bill will be.

Uncertainty is an anathema to household and business planning. So let me propose a basis for a new tax code and tax policy based on certainty. It includes three broad-based revenue sources that are equitable, transparent, and steady across economic cycles: a national sales tax, a business revenue tax, and a personal income tax -- nothing else. No Social Security or Medicare taxes for employee or employer, no unemployment taxes, no commodity taxes, no exemptions, no deductions, no subsidies. All rates would be known with certainty: 5 percent on all sales, 5 percent on top-line business revenue, and one rate (to be determined with budget surpluses in mind) on personal income with the first $25,000 a year excluded to aid the working poor. And with certainty comes a bonus: no annual tax filing, just reconciliation of an IRS statement.

There's much to be done on constraining spending. Across-the-board percentage cuts damage effective, efficient programs without accurately cutting ineffective, bloated programs. And maybe now is not the time to talk about good economic cycles; debt solutions cannot be put in place and into practice in the short run. But short-term solutions have to keep long-term goals in mind.