The Risks Beyond Our Means

03/07/2012 8:00 am EST

Focus: OPTIONS

John Mauldin

Chairman, Mauldin Economics

National debt is the heaviest and most destructive millstone you can tie upon an economy's neck, observes John Mauldin of Outside the Box.

The growing debt and deficit are a deadly cancer on the economy. It will deliver a mortal blow to the economy if not dealt with.

As I recently experienced in my family, it is better to deal with a cancer as soon as possible. Putting off treatment will not make the cancer go away by itself, and the cancer of our debt is clearly growing and malignant. It will soon overwhelm our national economic body.

But dealing with a cancer is not without cost and pain, whether on a real, personal level or a metaphorical, national level.

The problem is solvable. It is not that there are not a lot of solutions. It is that we have not yet found the political will to decide what course of treatment is needed.

Let's start with a few basic presuppositions that I think must be addressed in order to marshal an effective set of choices.

It has to be politically feasible. The Right would like to address the problem with spending cuts and reforms. Reforms and spending cuts are necessary, but not sufficient to deal with the problems.

For instance, disability payments are now running $200 billion a year and growing rapidly. Some 25% of those unemployed since the beginning of this crisis have somehow qualified for disability payments.

We can cut the time allowed for unemployment benefits, but that does not offer large numbers. Government transfers now account for 22% of household income. Cutting that will be politically difficult.

The real problem is health care. How much do we want, and how do we want to pay for it?

Health care must be thoroughly reformed, but the will (the votes) to go back to the 1990s is just not there. Rising costs can be controlled, but not eliminated.

The same goes for Social Security. We can raise the retirement age, do means testing, and make other changes, but the fact is that there are more Baby Boomers retiring each year. There is no Social Security Trust Fund. The money was spent on other projects, and now Social Security runs in the red each year.

What Republican is running on a platform of taking away Social Security from those who are presently receiving it, or will be eligible for Social Security within ten years? Want to cut defense? Military pensions? Government pensions?

And the Left wants to solve the problem by raising taxes on "the rich." We are down well over $1 trillion a year in our deficit. Obama's new plan raises taxes a lot, and still has $1.3 trillion in deficits—with very rosy assumptions.

"According to The New York Times, the president's plan to abolish the Bush tax cuts for those making more than $250,000 is expected to bring in merely $0.7 trillion over the next decade, or about 0.4% of Gross Domestic Product per year [about $60 billion in the coming years, under optimistic projections that assume higher growth and no recessions].

As a comparison, the Congressional Budget Office estimates that the deficit over the same period is going to be $13 trillion, more than 6% of GDP per year.

 "The rich in America obviously have lots of money, but there are simply not enough of them to fund the president´s preferred level of spending." (American.com)

The hard reality is that the rich just don't make enough to cover our current deficit. If we raised taxes to something like 60% on the top 10% of income earners, not just the 1%, we might get enough tax revenue...if the "rich" cooperated by making the same income they do now. That type of tax rate is just not politically feasible under any conceivable elected Congress.

It will require both spending cuts AND different and higher forms of revenue to get a deficit reduction plan through Congress, even a majority Right or Left Congress. If Obama could not get higher taxes (except for health care in the future) in his first two years, with a decidedly Democratic Congress, it is very unlikely to happen in time to deal with the deficit crisis.

Something must be done soon. We don't have another five election cycles to debate this.

We have unfunded liabilities that simply cannot be paid under any tax scheme. Those promises will not be kept, because we will not have the money in future years, and it gets worse with each passing year.

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Tax rates matter to the growth of the economy. Even a low estimate of the results of raising taxes by 10% reduces GDP by about 0.4% of the increase in taxes.

There are studies by very credible economists of both political parties, which I have written about in detail, that show that tax cuts and increases have a multiplier of as much as three as to their effects (Romer, as an example). An average estimate would give you something like a multiplier of two.

I have read no studies based on actual statistics (and not some untested theory) that suggests that taxes have a neutral effect. To suggest taxes have no effect on the economy makes for good sound bites, and is nice in theory, but the studies of actual statistics simply do not support that idea. Increasing the taxes on the rich may be "fair," but it is not GDP-neutral.

Kennedy, Reagan, and Bush cut taxes, and the economy grew and more taxes were collected in total within a few years. But we are no longer able to cut marginal income tax rates and borrow to pay the deficit, waiting for growth to happen to make the cuts "pay for themselves."

We have simply borrowed too much. We are close to the limit. We must find other options.

Some taxes appear to have less effect on economic growth, although I cannot argue that we have enough data points or serious academic studies to prove it. Reagan cut marginal income tax rates in 1986, but paid for it by getting rid of numerous tax deductions, so the overall affect was revenue-neutral. But the economy sure did grow after that.

People (at least US citizens) clearly adjust their spending, investments, and incomes in response to marginal income tax rates. I am not arguing "fair share" or the morality of income distribution, simply observing a fact.

The principle is if you want more of something, then lower the taxes on whatever it is, and vice versa. If you want to increase overall national income (again, not talking about the fairness or how it is distributed), then tax it less.

This idea is not radical. Rather, it is well accepted by nearly all political types. Congress (both parties) has passed more than 3,000 laws giving tax breaks to encourage certain types of economic behavior they deem to be good. Mortgage interest-rate deductions, charitable deductions, tax breaks for married couples and children, and so on down to very minor and industry-specific breaks. They all assume that taxes affect behavior.

Some level of government spending is necessary, although what is necessary by one person's lights may be seen as a waste by another. But governments should provide for the common need what a free market would not do. Defense, as an example.

Is health care a common right? A majority of voters certainly think so. Education? Roads? Regulations on certain industries? Again, a serious majority of voters think so.

One might argue for something less, and certainly Ron Paul does so rather well—with a growing following over the years I have known him. But such a vision is not politically feasible in the next four years.

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