A Potential Debt Solution

I was in a briefing preparation and presentation class at work in March. One of the assignments involved presenting research on a briefing that I felt affected the nation. Based on the title of this post, I'll give you one guess what my topic was.

Most of the data presented is from a few years ago, mostly because all of the financial data for last year is being tabulated this year and it takes a couple of years to crunch the numbers. As a result, some of the projected values will be a little off due to recent events. It is what is available to work with, though, and the numbers aren't likely to be very far off.

The best thing to start with, in my opinion, is a look at projected expenses of the U.S. government for the foreseeable future. I think a 75 year projection is pretty worthless and stick with the first half of the projection for future topics, but it's eye opening to see what would happen if income remained the same relative to the U.S. gross domestic product, expenses did not change aside from what is already promised in law, and the government was allowed to continue to borrow money at present interest levels. Note that gross domestic product is a measure of the total value of goods and services the country produces annually; historically U.S. GDP has increased a couple of percent each year. The possibility of indefinite borrowing at present interest levels is unlikely, in my opinion, because increased levels of debt will normally result in demands of higher interest repayment from the lenders due to the heightened risk associated with a debtor with a lot of debt. As you can tell from the figure below (annual expenses as a percentage of GDP according to the 2007 GAO Citizen's Guide), Social Security, Medicare, Medicaid, and interest payments will command the entirety of the collected revenues from the United States by approximately 2032. Additionally, interest on the debt becomes the largest single expense of the U.S. government around the year 2045 and net interest becomes more than all other predicted expenses combined 15 to 20 years later. Recall that this projection maintains today's interest levels. It is obvious that something needs to change. But what, exactly?

As has been discussed at length in the news recently, there are three possible options for improving the situation: increase income, decrease expenses, and a combination of the previous two. Unfortunately, each of these is problematic for politicians because people don't like paying more in taxes and they also don't like to give up benefits. It is equally unfortunate that politicians work harder on getting re-elected than doing what is best for the people they represent, an attribute which has produced substantial monetary waste in the form of poorly thought out, poorly executed, or irresponsibly managed programs. Ultimately, everyone who has a stake in the future of this nation needs to understand that shared sacrifice will be required to combat this problem.

The first option of increasing income will require taxes to become oppressively high in order to become effective. Referencing the first figure, Social Security and Medicare are the two largest expenses currently and for the next several decades, and borrowing to satisfy all of the promises of these programs contributes significantly to the debt that is expected to continue to mount. To fully fund these programs indefinitely a Fortune economist reported that revenues will need to be increased by 8.1% of GDP forever. Since 2010's GDP was $14.66 trillion (I'll present this later), 8.1% equates to $1.19 trillion extra dollars in taxes. I'll also present later that the IRS reported 2008 data (the most recent available, at least in March) that shows the total federal income tax paid by everyone was $1.03 trillion, so everyone's income taxes would need to more than double in order to fully fund Social Security and Medicare. If you prefer to consider how much more higher income earners would need to pay, the federal income tax of everyone earning above $160,000 would become 72% in order to not change the tax of people earning less than $160,000. Bear in mind, though, that this does not include FICA taxes (7.6% for Social Security and Medicare), state taxes, or local taxes. Including everything means these people would pay approximately 85% of what they earn in taxes, leaving only $24,000 in income for someone who earns the threshold $160,000.


The second option of decreasing revenue is similarly bleak when the numbers are exposed. Unfortunately I don't have a figure or a source for this, so you'll just have to do your own search if you don't trust me. In any case, the facts are simple. For the first eight years of the previous decade annual deficits amounted to approximately $400 billion. In order to rectify this imbalance, expenses would need to be reduced by 13%. Recent events have resulted in significantly more expenses by the federal government, though, to the tune of approximately $1.3 trillion in annual deficit from 2009 to 2011 (with deficits in the trillions for several years hence), which would require expenses to be reduced by more than 30% for a balanced budget. I don't know where to cut to solve this problem. Do all programs only get 2/3 of what was originally allocated? Do some programs get cut completely while others remain untouched? I really don't know. Personally, I think that every program should take a hit of at least 10% with some being fully cut. The fact is that there are some redundant programs; cleaning these up would help a bit, but this would require representatives telling their constituents that they'll lose stuff. Anyway, I only had one day to research and ten minutes to present so I completely ignored reducing expenses due to the complications involved, even though it would help quite a bit. There would be some short term problems, but successful programs would learn to run more efficiently, people would learn to live with the new situation, and things could be tweaked every few years in response to needs and desires.

I hinted at my proposed ideal solution of reducing expenses while raising taxes in the previous few paragraphs, but as mentioned the process of reducing expenses gets hairy quick because people (voters especially) get in the ears of lawmakers and voice their displeasure when such measures are even proposed, much less enacted. So while I think a combined solution would be the best way forward, a simple alternative using only modifications in obtaining revenue would put the taxpayer in control by introducing a 20% consumption tax in lieu of the personal federal income taxes currently paid. Note that this tax does not include the FICA tax (Social Security, Medicare, and Medicaid) or the state or local taxes, so a person who spends his or her entire income would ultimately be able to spend approximately 70% of the gross income with the other 30% taken in taxes. Please recall that the 20% consumption tax could decrease with reductions in spending as a percentage of GDP (remember GDP tends to increase annually), but I didn't want to account for any spending reductions and instead keep all expenses. In the next few paragraphs I'll explain how a consumption tax is different from doubling the current income tax.

First I should mention that I would not only keep the 6.2% tax for OASDI (old age, survivor and disability insurance, aka Social Security), I would also remove the limit beyond which no tax is levied. Currently an individual earning $106,800 pays $6621 in OASDI tax, which is exactly the same tax as someone who earns $106,800,000 due to the tax limit. Removing this limit and collecting both the 6.2% tax from both employer and employee regardless of wages would fully fund Social Security for the foreseeable future. To help explain this, the figure below shows the IRS tax report from 2008 (AGI stands for adjusted gross income). The top 10% of income earners earned at least $113,799 in 2008. That's close enough to $106,800 for me, but my quick calculation actually misses all those between $106,800 and $113,800 because I don't know how many people are in that gap so the additional tax revenue will be slightly low. Anyway, the first column shows 13,996,058 people in the top 10% with a total AGI of $3.86 trillion. These people have been taxed 6.2% on their first $106,800, which means $1.49 trillion has already been taxed. But this still leaves $2.37 trillion untaxed.















Now, since the 6.2% applies both to employer and employee, the actual percentage collected is 12.4% (self-employed people have to pay the full 12.4% on their own), and 12.4% of $2.37 trillion is $293 billion, or approximately 4.8% of total taxable payroll (subtracting $2.37 trillion from a total AGI of $8.43 trillion gives the current taxable payroll amount of $6.06 trillion, and 293/6060 is 4.8%). Adding 4.8% to the current 12.4% gives 17.2%, which is the black line added to the figure below from ssa.gov. As you can see, removing the cap on OASDI tax not only completely fixes the problem of under funding with Social Security, it also provides approximately 0.7% additional revenue relative to total GDP (this 0.7% is a little over $100 billion in 2010 dollars).

Finally I would like to address the consumption tax. A 20% consumption tax on goods and services would mean that a gallon of milk at $3.00 would instead cost $3.60 and a $100 dress would cost $120 not including sales tax. However, you would not have to worry about keeping track of all of your tax forms for the year or hire an accountant to do your taxes because there would be no 1040 to fill out. Additionally, you would not have any federal income taxes removed from your paycheck and would be able to choose what to spend your money on. So, a person with an annual net salary of $25,000 (after FICA taxes are removed) would be able to purchase $20,000 in goods and services in today's prices and expect to pay $5,000 in tax. However, if that person instead chose to spend $20,000 of the $25,000 and save the rest (purchasing the equivalent of $16,000 in today's prices), he or she would instead only pay $4,000 in consumption tax and would be able to save an additional $1,000. This is because savings is not taxed, nor is any interest earned from saving or investing. You are only taxed on what you spend, and this puts you fully in control of your own money.

I mentioned that there would be no need for filling out federal 1040 forms for income tax. This would also mean that there would be no tax breaks for going to school, having a mortgage, being the head of a household, and the like. However, since I didn't touch anything regarding federal expenses with the consumption tax, these tax breaks are effectively built in to the expenses because the U.S. government is telling you that you don't have to pay them a certain amount of money. So in lieu of giving you tax breaks for going to school, having dependents, etc., the government can instead simply cut you a check. It's basically the same thing, and it would make the books a lot easier. Additionally, the consumption tax is likely to be more difficult on low income workers because the percentage of their income they spend on necessities is higher when compared to higher income workers. These people would still be able to take full advantage of federal assistance programs that are currently available, and some people could be exempt from paying consumption tax on certain necessities to further assist them should a consumption tax be introduced. I really haven't figured it out, but since the bottom 50% of income earners only paid a total income tax of $27 billion in 2008 (from the table above) I expect any meaningful reduction in federal spending, which I purposely omitted, would more than make up for this additional expense.

The next paragraph explains what a consumption tax actually means in terms of revenue. Here is the breakdown of 2010 numbers, with the changes I mentioned throughout this post included.

FICA tax (payroll taxes) -- $690 billion
Additional OASDI tax from removing the limit -- $300 billion (approximately the same as 2008)
Corporate income tax -- $191 billion
Other taxes (estate, excise, customs, etc.) -- $207 billion
Consumption tax -- $2,070 billion (see the chart below from bea.gov for personal consumption expenditures in 2010 of $10.35 trillion, 20% of which is $2.07 trillion)


This equates to a total federal revenue of $3458 billion for 2010. The 2010 expenses for the federal government totaled $3552 billion, which means the 2010 deficit would have been $94 billion. However, recall that 2010 included several unusual federal expenses in the form of bailouts and payroll tax reductions which lowered total revenue; in a more normal year the federal government would have run a surplus instead of a deficit. Compare this with the actual numbers from 2010. The expenses were the same at $3552 billion, but the revenue was $2381 billion. This equated to a deficit of $1.17 trillion in 2010, which is about 12 times more than the $94 billion deficit with a 20% consumption tax and additional OASDI taxes.

The figure below shows what a consumption tax means for the future. The left part shows the portion from 2010 to 2050 from the very first figure and the breakdown of Medicare, Medicaid, Social Security, interest on the debt, all other government programs, and the expected revenue as a percentage of GDP for that year (recall that GDP has historically grown each year). The right portion of the figure is the same graph with Medicare and Medicaid combined and revenue at a steady 25% of GDP. The right portion is pretty illegible, but I basically duplicated the left portion with the GDP scale on the y-axis and expected expenses every 10 years from 2010 to 2050 on the x-axis. You can recognize from the figure three things. The first is that the current situation is unsustainable, and that something needs to be done to change it. The second is that the 2010 values from the right portion show a net surplus with revenue more than expenses, though I stated otherwise in the previous paragraph. This is because the figure I am comparing to was from 2007 which did not include the recent bailouts, etc., so I didn't include them in the figure on the right, either. The third thing is that, in contrast to the figure on the left, the red bar indicating interest paid on the debt disappears by 2030. This is because the debt would be projected to be paid off in less than 20 years using the 2007 GAO numbers.



I want to make clear that the method I proposed is not the only method of solving the debt problem. I don't even think it is the best solution, because I didn't include any reduction in federal expenses and I think a reduction in expenses should be included. Still, righting the ship is possible. I'm not sure how many people would be in favor of a 20% consumption tax, but as I mentioned before something needs to be done. With the consumption tax, at least they would be able to determine why and to what extent they are taxed. Thank you for reading everything; I know it was long, but hopefully it was worthwhile.