Tax Cuts Will Solve Our Unfunded Liabilities Problem

Taking into account promised Social Security and Medicare benefits, the Federal Government is effectively bankrupt. Our only hope is to cut taxes. Perhaps I should explain.

There is much wailing over the “National Debt”, but this is not a significant financial problem. Federal (Treasury) debt held by the public is about $5.1 trillion. This sounds huge, but it amounts to only about 2.5 percent of the “present value” (PV) of future Federal tax revenues. If your debts (counting interest) were equal to only 2.5 percent of the present value of your future income, neither you nor your creditors would be very concerned. This is one reason that, right now, the financial markets are willing to lend the U.S. government money at a real interest rate of only 1.79% (30-year Treasury Inflation-Protected Securities).

In contrast, the PV of the “unfunded obligations” of Medicare and Social Security total almost 43% of the PV of future Federal tax revenues. Throw in the Treasury debt and unfunded Federal retirement benefits, and you get “debts” that equal $95.8 trillion, which is almost 48% of the PV of future Federal tax revenues. Given the other needs to which the Federal government must devote tax revenue, this debt load is financially unbearable.

The government’s financial problem could be solved simply by cutting promised Social Security and Medicare benefits drastically. However, this is considered politically impossible, so what is generally discussed is a combination of tax increases and benefit cuts. Unfortunately, any kind of tax increase would almost certainly make the government’s financial problems worse.

What is not widely understood is how sensitive Federal finances are to economic growth, and how sensitive long term growth rates are to tax rates; particularly those on capital. The “present value” calculations that the Social Security Trustees use to estimate Social Security and Medicare “unfunded obligations” tell the tale.

The Trustees (2006 Report) estimate the PV of future Gross Domestic Product (GDP) at $1117.3 trillion. The current Federal tax structure captures about 18% of GDP, which puts the PV of Federal revenues at $201 trillion. The purpose of a tax increase would be to increase the PV of Federal revenues. If it didn’t do that, it would do the government no good.

Congress traditionally estimates the revenue impact of tax changes via “static analysis”, which assumes that tax changes have no impact upon the economy. Static analysis would say that the Federal government’s financial problems could be solved by simply increasing all Federal tax rates (income taxes, corporate income taxes, payroll taxes, etc.) by 48%. This would increase the Federal government’s take “take” from the current 18% of GDP to 27% of GDP. This, in turn, would increase the PV of future Federal revenues by $95.8 trillion and offset all Federal “debts”.

Unfortunately, static analysis isn’t realistic. Whatever you tax you will get less of, so any form of tax increase will slow economic growth. In the real world, it is surprisingly difficult to increase the PV of future Federal revenues by raising tax rates.

Furthermore, a 48% across-the-board tax increase would cause another Great Depression. However, let’s say that it didn’t. If such a tax hike cut the long-term real economic growth rate by only 0.55 percentage points (from the Trustee’s assumption of about 1.9%), there would be no increase in the PV of future Federal revenues at all. Financially, the Federal government would be back where it started, while the PV of future income available to the rest of the nation would be cut by more than 40%.

Taking a less extreme case, many are calling for reversing the 2003 tax cuts. Static analysis would say that doing so would increase the Federal tax “take” to about 20% of GDP from the current 18%. However, if this huge tax increase cut our average long-term growth rate by only 0.12 percentage points, the Federal government would be no better off (and the rest of the country would be much worse off). Given the massive increases in GDP growth and Federal revenues that followed the 2003 tax cuts, reversing them would be insanely risky from a financial point of view.

So, if the Federal government’s financial problems can’t be solved by raising taxes, what can be done? The Social Security Trustees’ financial methodology points to the answer: cut tax rates to achieve faster GDP growth.

GDP growth is most sensitive to taxes on capital, especially to the Corporate Income Tax (CIT) and the Death Tax. Repealing the CIT and the Death Tax would cut the Federal tax “take” from 18% of GDP to about 16%. Evidence from around the world suggests that doing this would cause economic growth (and wages) to skyrocket. Tax cuts much smaller than this propelled Ireland to an average GDP growth rate of over 7 percent for the past ten years.

But let’s say that GDP growth didn’t skyrocket. If these huge tax cuts increased long-term GDP growth by only 0.13 percentage points, they would “pay for themselves”, in the sense of maintaining the PV of Federal revenues. If they increased growth by only 0.45 percentage points, they would increase the PV of future Federal revenues by $95.8 trillion, thus offsetting not only the tax cuts, but all Federal “unfunded obligations”, including the “national debt”. At the same time, the PV of the income available to the rest of us would increase by more than 75%.

Obviously, cutting taxes would require additional Federal borrowing for a few years. However, the financial markets would be eager to provide the funds because they lend based upon their calculations of the PV of future Federal revenues, which is what determines the government’s ability to service its debts.

With the economy on a fast growth track, the Federal “deficit” would melt away, as it did in the late 1990s and is doing right now. Future Social Security Trustees Reports would say that the Social Security + Medicare “unfunded obligation” problem was disappearing.

Meanwhile, real wages would start growing rapidly again, as they did in the 1960s. The nation would finally have the experience of real prosperity. Cutting—not raising—taxes is the way out of the Federal government’s financial hole.