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Which Party Has a Tax Problem?

The media say Republicans, but it’s actually the Democrats.

Jul 4, 2011, Vol. 16, No. 40 • By JAMES PETHOKOUKIS
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But AEI’s scholars created a plan that would boost tax revenue to a consistent 19.9 percent of GDP by replacing the income tax with a broad consumption tax and substituting a carbon tax for alternative energy subsidies. Only three years in U.S. history have seen higher tax levels as a share of output. The team’s explanation: “We cannot simply tax our way to a balanced budget without suffering the consequences of a -sluggish economy and reduced prosperity. We also cannot simply cut spending without risking the loss of essential services for an aging population, undercutting our infrastructure on which economic growth builds, and reducing our ability to defend the country against its enemies.”

So does all this amount to a schism on taxes or repudiation of an economic approach that brought the Republican party out of its post-World War II political wilderness and helped extend America’s global economic superiority into the 21st century? Not so much.

Actually, it’s Democrats who face dangerous fiscal fissures. Here’s why: Under an alternate financial forecast from the Congressional Budget Office—one more likely than its baseline prediction—spending as a share of the economy is headed toward 34 percent of GDP by 2035 versus 21 percent historically and 24 percent today. But the economy would never arrive at this point without being crushed under a monstrous tax and debt burden. The mainstream economic and political consensus—except among liberal Democrats, really—is that spending needs to be closer to 21 percent of GDP. The Obama commission would cap spending at that level, as would bipartisan plans fashioned by Senators Bob Corker, a Tennessee Republican, and Claire McCaskill, a Missouri Democrat.

The left hates this idea for two reasons. First, it means at least 85 percent of future debt reduction ultimately would come from cutting government. As it so happens, that 85-15 ratio of spending cuts to revenue increases is typical of the fiscal policy mix other countries have used to successfully escape from debt traps. Second, hitting that 21 percent mark would mean—perhaps—modest tax concessions from Republicans. Democrats, on the other hand, almost surely would need to agree to sweeping entitlement reform, probably along the lines advocated by Rep. Paul Ryan. The union-backed Economic Policy Institute, for instance, has a debt plan that puts spending at 28 percent of GDP by 2035 thanks to its embrace of a government-centric health system. At some point, Democrats will need to have an interesting internal conversation about whether a social safety net designed for the demographics of the 20th century is appropriate for this one.

What’s more, there’s every reason to believe that pro-growth policies can produce added tax revenue by making the U.S. economy bigger.  The AEI plan, for instance, was required to use the gloomy economic forecasts of the CBO, which assume long-term GDP growth of around 2 percent. But many economists believe replacing the current income tax system with a more economically efficient consumption tax would boost long-run output. If growth were substantially higher than the CBO assumes, then the long-run revenue requirement to make the numbers work could be in the neighborhood of 19 percent of GDP—the same as in Ryan’s “Path to Prosperity.” But the pie would be bigger.

And there’s a lot more that can be done to increase growth beyond tax reform. The AEI plan, for instance, doesn’t touch on regulatory reform or increasing high-skilled immigration or implementing market-friendly approaches to infrastructure and basic research spending. All would boost tax revenue by boosting long-run GDP growth.

The prospect of modest tax hikes in exchange for radical entitlement reform is no reason for the American right to fracture. But with smart pro-growth policies, there would be no reason to raise taxes at all.

James Pethokoukis is a columnist for Reuters.

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