Backing into a value-added tax
Biden's proposed budget illustrates that a European-style social democracy cannot be financed strictly through higher taxes on corporations and the rich.
The issue of the federal government’s cumulative debt and annual deficits is slowly returning to the political agenda.
Not enough to motivate or require the presumptive presidential nominees of the two major political parties – Joe Biden and Donald Trump – to say or propose anything serious or substantive about it. But there is increasing attention to it in the intellectual fringes of the policymaking process on both the left and the right.
Events are forcing the issue to the surface. When the federal government seemingly could borrow unlimited sums at very low interest rates in perpetuity, the issue was a sleeper. There are clear signs that those days are coming to an end, if not already in the past. Interest on the federal debt is soaring, eclipsing what is appropriated annually for defense. Inflation and interest rates seem stuck at an elevated level.
Because so much of the federal debt is in shorter-term instruments, much of it has to be refinanced in these less favorable market conditions. Sustained trillion dollar plus deficits means issuing a lot of new debt in the same conditions. Meanwhile, participation in the auctions held to place this debt is waning.
The politicians may not be able to ignore the issue substantially longer. In preparation for that day, some reality checks are in order.
Biden and Democrats want to transform the political economy of the United States into a European-style social democracy, with a vastly expanded social welfare system. They have been peddling the fiction that this can be financed exclusively through higher taxes on corporations and the rich. Given that the backstop of just borrowing the money is considerably shakier, getting past the fiction grows in importance.
Biden’s proposed budget for the 2025 fiscal year, which begins this October, is useful in this regard. Not because his budget has any hope of actually being enacted. But because it offers the most comprehensive blueprint of the proposed transformation of the political economy and illustrates the fiction of financing it through higher taxes on corporations and the rich.
The proposed budget has plenty of them. The corporate income tax rate would be increased from 21% to 28%. The top individual rate would be increased from 37% to 39.6%. The top rate would kick in at a much lower income level, $450,000 for a joint return compared to the current $731,200. Those earning $450,000 currently pay a marginal rate of 35%, so that’s a substantial increase.
Those making more than a million a year would have to pay regular income tax rates on their capital gains, rather than the lower capital gains rate, nearly doubling the tax take. Those with a net worth of $100 million or more would have to pay taxes on their unrealized capital gains. Accountants and tax attorneys would make a fortune in calculating and arguing about the value of an unsold asset and the annual revisions required to account for fluctuations in the value.
For high earners, the Medicare income tax surcharge would be increased from 3.8% to 5%.
This is hardly an exhaustive list. There is a score or so of additional provisions to squeeze more revenue for the government out of corporations and more affluent individuals.
I’ve written periodically about the blind eye Democrats in general have about the importance of investment capital to fuel the private sector economy. These tax proposals would remove hundreds of billions of dollars from the private economy annually. Yet, Biden’s budget boffins assume that has zero effect on private sector economic activity and growth. The ten-year projection in the budget assumes a steady growth in real GDP of around 2%.
Biden’s tax increases would give the United States a substantially less favorable investment climate than prevails in Europe. The corporate tax rate in Europe averages the 21% the Trump tax cut created for the U.S., compared to the 28% proposed by Biden. And that’s before layering on state corporate income taxes.
For individuals, the top rate in the United States, including state levies, is roughly the same as the European average of 43%. The Biden tax hikes would put the marginal rate in the United States around 50% in most states, greater than that in some.
At 21%, the average capital gains tax rate in Europe is roughly equivalent to the current treatment in the United States. The Biden tax proposals would more than double the European rate at the top end.
What’s most important about Biden’s proposed budget is all these tax increases barely change the debt outlook.
There are some highly favorable assumptions in Biden’s ten-year forecast. The economy grows steadily, unemployment remains historically low, interest rates and inflation substantially abate.
Yet, despite the tax hikes and these favorable assumptions, the annual deficit in Biden’s budget projection is below $1.5 trillion in just one of the ten years, and barely below in that year. The average annual deficit is $1.6 trillion. The cumulative debt increases from $33 trillion to $52 trillion.
The Euro zone has a rule, often violated, of limiting annual deficits to 3% of GDP, a level believed to be compatible with sustainable government finances. The Biden budget runs chronic annual deficits in the 4.6% range.
A lot of the explanation lies on the spending side. Pre-Covid, federal spending was 21% of GDP. During Covid, it leapt to 30%. Rather than return to the pre-Covid level, or slightly above it to accommodate an increasing number of retirees on Social Security and Medicare, Biden would retain spending at an elevated rate in excess of 24% of GDP. That’s the price of establishing a European-style social democracy in the United States.
But, as the Biden budget clearly illustrates, a European-style social democracy cannot be sustainably financed strictly through higher taxes on corporations and the rich. Not even close.
I have long believed the Democratic blueprint was backing the United States into a value-added tax, a sales tax imposed at each stage of production. That’s the missing revenue source most capable of putting the federal government’s finances on a solid and sustainable footing, particularly at the elevated level of spending Democrats advocate.
In Europe, the average VAT is 21%. It generally generates roughly a fifth of government revenue in Europe. Hard to have a European-style social democracy without the European method of paying for it.
A federal VAT in the United States is complicated by the fact that, here as opposed to in Europe, state and local governments have already filled up the sales tax space considerably. Nevertheless, a federal VAT discussion is probably in our future, and it is not one economic conservatives should dismiss out of hand.
As a general proposition, economic conservatives prefer consumption taxes to taxes on income, investments, or property. Economic conservatives would prefer that it not be used to fund a European-style social democracy, but a much smaller and limited federal government.
The political reality, however, is that the Republicans are no more serious than the Democrats about getting debt and deficits under control. Trump was the first Covid profligate spender, supported by congressional Republicans. He is indifferent, even favorable, to debt. He has engaged in some loose talk about defaulting on the U.S. sovereign debt. He is a low interest rate, big borrowing guy. His election would not reassure a nervous market for U.S. sovereign debt.
Since Paul Ryan left town, there is no consequential Republican in Washington with the slightest interest in making the tough political decisions to fix the finances of the federal government at a spending level substantially below that advocated by Democrats.
Both parties are sleepwalking toward a fiscal reckoning which may have begun. When the consequences become impossible for politicians to ignore, the possibility of a U.S. VAT may creep toward center stage.
Reach Robb at robtrobb@gmail.com.