Four Steps to US Fiscal Health

The United States has a significant budget deficit, likely to be $1.3 trillion (10 percent of GDP) this year, and the long-term forecasts are worrying. According to the Congressional Budget Office (CBO, the leading nonpartisan experts), Social Security-together with Medicare, Medicaid, and other healthcare programs-will grow to consume almost all tax revenues by 2035.

The United States can finance these deficits in the short term-in fact interest rates on US Treasuries have recently fallen to record low levels. But if there is no serious effort at fiscal consolidation, serious trouble lies ahead, both for the United States and for the world economy. Thus, the United States urgently needs to begin making four serious changes.

The first is comprehensive tax reform aimed at aligning tax policy with desirable economic incentives. In particular, the United States should consider introducing a value-added tax (VAT), widely used in other industrialized countries. By levying a tax on consumption at each stage of the production chain, America could reduce the overconsumption that helped feed the recent credit bubble, encouraging savings and investment instead. To be sure, a simple VAT is regressive, though it can be made progressive by combining it with a partial rebate or by exempting necessities.

Moreover, the United States should look hard at tax breaks that act like hidden spending programs. One place to start is the tax deduction for interest payments on home mortgages. The deduction is currently available on mortgages of up to $1 million, thus forming a key component of America's excessive incentives to buy houses-a policy eschewed by most other industrialized countries.

The second change is carbon pricing, either by auctioning emissions allocations or by taxing carbon directly, at rates that start low and rise over the coming decades. Given large potential revenues-in 2008, the CBO estimated that one proposal would yield $145 billion in 2012 and more in subsequent years-it would make sense to dedicate a portion to cushioning the impact of higher energy prices on the poor, while applying the rest to the fiscal balance.

Opponents argue that carbon pricing would hurt economic growth. But a recent study commissioned by the Economist found that a carbon tax would increase both government revenue and economic output-primarily by replacing existing, inefficient energy subsidies.

The third change is a tax on the financial sector, in the form of a Financial Activities Tax on profits and remuneration at big banks that enjoy implicit government guarantees. The International Monetary Fund estimates that this form of value-added tax could bring in between 0.5 and 1 percentage point of GDP in revenue.

Such a tax, moreover, would aim to eliminate the funding advantage that large banks enjoy over their smaller competitors, while limiting the incentive for big banks to become even bigger. As the IMF argues, if applied across the G-20, a Financial Activities Tax would help constrain the worst features of the financial system and reduce the competitive distortions created by the megabanks.

Finally, there is the issue of entitlement spending, which is mainly an issue of healthcare costs. According to the CBO's alternative fiscal scenario, growth in Social Security is comparatively modest, from 4.8 percent of GDP in 2010 to 6.2 percent in 2035. A relatively small change in the parameters of this program could lower its future costs, as was done in the 1980s. At the same time, however, the relative cost of Medicare, Medicaid, and other healthcare programs will more than double, from 4.5 percent to 10.9 percent of GDP.

There are two ways to reduce the government's healthcare outlays: reduce the amount of health care the government buys, or reduce the cost of health care. The simplest solution is to mandate that the government buy less health care-by raising the eligibility age for Medicare, capping benefits for high-income beneficiaries, and so on.

The problem with this approach is that Medicare is not particularly generous to begin with. If the eligibility age were to increase, responsibility for health care for many people would simply be dumped back onto their employers, resulting in higher healthcare costs for all working people. A better solution is to figure out how to reduce healthcare costs.

This year's healthcare reform legislation, the Affordable Care Act (ACA), is a starting point. According to CBO data, the ACA will reduce the long-term fiscal deficit by 2 percentage points of GDP per year. A top priority should be to preserve and expand its cost-cutting provisions. Another obvious step to consider is to phase out the tax exclusion for employer-sponsored health plans, which would not only increase revenue, but also end the distorting effects of employer subsidization of health care.

But efforts to tackle healthcare costs continue to be hampered by widespread reluctance to tackle sensitive issues, as epitomized by the "death panel" tempest of a year ago. Reshaping the US healthcare system to focus on successful outcomes and quality of life, rather than on employing the newest and most expensive technology, is a challenge for which no one yet has a proven solution. It remains, more than any other single factor, the key to long-term fiscal sustainability.