Tax rates are at their lowest levels in 80 years! Amongst the tools available to balancing the Federal budget, it is the easiest factor to control and has the biggest economic impact.
The top income tax rate is now at a historically low level. The TCJA law further reduced the tax rates for all income levels.
The future for taxes does not bode well when viewed in terms of balancing the Federal budget. The budget deficit is growing and closing in on ≈$1T. A more in-depth look at this topic can be found in “Macroeconomic View of Entitlement Programs.” Let us examine the factors which affect Federal revenue and expenses (budget).
What increases the Federal Budget? The National debt is almost at 100% of GDP or ≈$20T and continues to grow. Servicing this debt in the form of interest payments costs 7% of the budget. Life expectancy increases by one year every decade due to the advances in healthcare. This increases the cost of providing entitlement programs such as Medicare and Social Security benefits. The increase in healthcare costs also drives up the cost of providing Medicare services.
What decreases the Federal Budget? The COLA or Cost-of-Living Adjustment is made to Social Security benefits to fight inflation. However, in today’s low inflationary environment, in which the rate hovers around 2%, COLA increases are either small or not required at all. The full retirement age has been increased from 66 to 67 for those born after 1960. Both these measures help reduce the cost of providing Social Security services.
What increases Federal Revenue? 2018 Federal revenue was $3.3T of which 80-90% came from income tax. Hence, increasing the amount of income tax has great economic benefits for balancing the Federal budget. The entitlement programs, Social Security and Medicare, each costs ≈$1T to provide, and consumes half the budget. Any increase in FICA tax rates or the salary cap for Social Security tax will alleviate the respective program deficits.
What decreases Federal Revenue? The worker-to-retiree ratio has been declining steadily over the last few decades and is now at the low point of 2.8, because of the ageing population and increasing life expectancy. This obviously means that while fewer people are contributing to the national treasury, more are starting to utilize the social safety net programs promised to them.
Let us summarize these factors in a 2×2 framework, with control the Government can exercise over these factors on one side, and the impact these factors have on balancing the Federal budget on the other.
Life expectancy is a slow-moving target that also has a minimal impact on budget, while soaring healthcare costs and declining W/R ratio are harder to control but has a bigger economic impact. Government can adjust COLA increases easily, however, it may not have a huge impact on balancing the budget.
The remaining factors that can help reduce the budget gap are increase in taxes, continued ability to borrow even bigger amounts and further increase in the retirement age. All these factors can have a swift and meaningful impact on budget control. The latter two factors are already in play leaving us with the only factor in the sand box that has not been touched in a while – a Tax increase!
A video presentation of this blog is available at “Macroeconomic View of the Future of Taxes.”
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