Worldly Wise: US faces up to deficit peril

Last week in Washington, beneath a flock of birds flying south in a majestic V formation, the co-chairmen of President Barack Obama's deficit commission released a plan that actually could solve the nation's pending fiscal crisis.

At once radical and sensible, the plan establishes the two chairmen, Democrat Erskine Bowles and Republican Alan Simpson, as visionaries. If Obama wants to deliver the country from the malaise it finds itself in, he should heed the advice of his appointees.

Let's be blunt about the problem at hand: The US is on a path toward the kind of debt crisis that has roiled Greece. The Congressional Budget Office estimates that, based on current policy, the debt held by the public as a percentage of gross domestic product will escalate to 87 per cent by 2020 from 62 per cent now.

The plan finds the sweet spot in the deficit debate, maximising money collected through taxation while requiring necessary cuts in government spending.

On the tax side, the authors understand the benefits of a broad base. Their emphasis on reducing tax breaks, including the deduction for money spent on home-mortgage interest, would allow for significant rate reductions, perhaps down to three tiers of 8 per cent, 14 per cent and 23 per cent.

Incredibly, the proposal also gets the top corporate tax rate, now 35 per cent, all the way down to 26 per cent, a long-overdue change that could make corporations rethink any plans to leave the US for less-taxing climes.

Appealing strategy

Beginning a tax overhaul by closing loopholes is a strategy that should appeal to those on the political left, the ones that so far are voicing the loudest criticism of the Bowles-Simpson plan.

A chart released with the plan shows that eliminating all tax breaks, other than the refundable credits targeted toward the poor, would reduce the after-tax income of those in the top one per cent of the income distribution by almost 14 per cent, those in the middle quintile by about four per cent, and those at the bottom by only about one per cent.

On the other side of the ledger, tough choices on entitlement spending would be phased in gradually to limit the pain. Social Security spending, for example, would be cut by raising the retirement age to 68 in about 2050 and to 69 by 2075, and the rate at which benefits grow over time would be reduced.

While I applaud the plan generally, I do have a few gripes.

Its strategy to reduce health-care costs — capping the growth of federal spending on health care at the rate of GDP growth plus one per cent, after 2020 — amounts to little more than wishful thinking that puts off the tough decisions. Bowles and Simpson would have gotten extra credit for specifying that most retirees need to cover more of the costs of their own health care with out-of-pocket cash.

Treating capital gains as ordinary income, as the chairmen propose, is a bad idea as well, because it moves us away from the economic ideal that taxes consumption instead of income.

Finally, I would have preferred if the chairmen hadn't included less-radical alternatives to their ideas. When the first option is clearly the best, why mess with second place?

Still, Bowles and Simpson produced a proposal in line with academic principle, not political nicety, which constitutes a pleasant surprise. I was certainly not alone in thinking that Obama's choice of them as co-chairs was more a nod to bipartisanship, even moderation, than to bold thinking.

What might the Bowles-Simpson consensus deliver, if enacted?

No fear

The probability of USdefault would be reduced to close to zero. Americans would be freed from fears of big future tax hikes. And the sickly US economy would get a dose of chicken soup that might produce surprisingly swift results.

In 1998, Victor Fuchs led a survey of 69 economists about the effects of the Tax Reform Act of 1986, which lowered rates by closing loopholes. The median response was that the tax overhaul added one per cent to annual GDP growth. If anything, the tax code is even more complex than it was pre-1986, so a similar GDP boost might be likely today.

Even the earliest critics of the Bowles-Simpson plan, those who jumped to the defence of entitlement programmes, must admit that their current path is unsustainable.