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The United States federal budget has become so large that a tax system like the one the U.S. has used for the past 99 years cannot possibly raise enough revenue to balance it. If spending is not reduced as a share of GDP, the U.S. government will eventually be forced to institute a Value Added Tax (VAT) on top of the income tax. Raising even more tax revenues at the federal level will harm the competiveness of the U.S., reduce growth, and lead to even fewer jobs and higher unemployment. The only way to head this off, and save the American system, is to reduce spending as a share of GDP. The federal budget of the United States has never been in balance, let alone in surplus, when the government spent more than 19.5% of GDP. In fact, there have only been eight years of balanced or surplus budgets in the 61 years since 1950; spending as a share of GDP averaged just 18.1% in those years. In other words, the more the government spends, the harder it is to balance the budget. This is true for three reasons. First, no matter the rate on the income tax, tax receipts are rarely above 19.5% of GDP. The top individual income tax rate has been as high as 90% and as low as 28% in the past 60 years, but revenues have remained in a fairly narrow range. Second, increases in government spending (past a certain point) can cause slower economic growth and higher unemployment, which undermines revenue growth. Third, government spending tends to rise when the economy falters. Recessions boost spending and reduce tax receipts. In 2011, government spending was 24.1% of GDP, and under President Obama’s budget proposal it is never going to fall below 23% of GDP. In other words, there is no tax regime in the history of the United States that has generated enough tax revenue as a share of GDP to balance the budget today, or in the future. As a result, the Obama Administration is arguing that “the rich” should pay more in taxes. Putting aside the fact that the wealthy already pay a majority share of total taxes, higher tax rates on the rich cannot possibly balance the budget. If high-income taxpayers paid a 100% tax rate on all income currently taxed at 35%, the government would only raise about $365 billion per year. With trillion dollar deficits as far as the eye can see, these taxes on the rich will never balance the budget. Moreover, a tax rate of 100% would induce massive changes in behavior. After a certain income level, doctors would stop seeing patients and instead paint their own homes because it would be a non-taxed benefit. Plumbers would do their own accounting for the same reason. In the end, unemployment would rise and the economy would become less efficient as doctors painted and plumbers did books. Simply put, trying to tax the wealthy would not work. It can’t possibly balance the current budget. If spending is not reduced, politicians will eventually turn to taxing the middle class. That’s where the money is, and by instituting a VAT they would have a better chance of raising significant amounts of money. A VAT is brutally efficient and it is regressive. It is hard to escape and even catches the underground economy. Most European countries — in fact, most countries outside the U.S. — have a VAT. In other words, three things are true. First, if government spending is not reduced the deficit cannot be closed. Second, if spending is not reduced a new tax system will be introduced in the U.S. and it will hit the middle class. Third, if this is allowed to happen, the U.S. economy will look more like Europe than it ever has. The result: slower economic growth, higher unemployment, and lower standards of living than would have existed without a VAT. Finally, using European history as a road map, even a VAT will not fix the long-term budget problems of the U.S. Governments in Europe face insatiable demands from taxpayers and spend more than the revenue from income and value-added taxes, combined, can provide. The result is a vicious downward spiral of lost economic growth, higher tax rates, more spending, and eventual default. Cutting spending is the only way to head off the institution of a Value-Added-Tax and an unsustainable increase in debt levels. This article originally appeared on Forbes.com on April 12, 2102.
2012 Economic Growth Fellow
Brian Wesbury is chief economist at First Trust Advisors L.P. in Wheaton, Illinois. He is a member of the Academic Advisory Council of the Federal Reserve Bank of Chicago. Formerly he was vice president and economist for the Chicago Corporation and senior vice president and chief economist for Griffin, Kubik, Stephens, & Thompson. From 1995-96 he served as chief economist to the Joint Economic Committee of Congress. His most recent book, “It’s Not As Bad As You Think,” was published in 2009 by John Wiley & Sons. He received an M.B.A. from Northwestern University’s Kellogg Graduate School of Management and a B.A. in Economics from the University of Montana.Full Bio
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