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The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of the United States 2005 published on 27 October 2005.
What needs to be done to achieve fiscal sustainability?
The improvement in federal finances has recently exceeded expectations, given strong growth in personal and corporate income tax receipts, and the deficit of the unified budget is likely to fall well below 3% of GDP in the current fiscal year. Under plausible assumptions about future policies, however, further progress towards reducing the deficit is likely to be limited. Persistent unified budget outcomes near the current level would entail a substantial additional rise in public debt, with the attendant negative effects on national saving and long run national income. Restraining discretionary spending, which had been growing at nearly 7% per annum in real terms over the previous four fiscal years, is a sine qua non but will probably make only a limited contribution unless defence spending can be curtailed. In any case, budgetary discipline needs to be reinforced, and reinstating fiscal rules in some form, such as the expired provisions of the Budget Enforcement Act, might be helpful in this regard. This is all the more important in view of the looming spending pressures from the retirement of the baby boom generation. Unreformed, rising ageing related entitlement spending would almost certainly lead to unsustainable future deficits. Unless the size of the government sector is significantly reduced, some increase in revenues will be necessary as well, highlighting the importance of tax reform to minimise the economic costs of raising revenues.
The budget outlook beyond the next ten years is dominated by projected spending on entitlement programmes, which under current rules is set to rise from 8% of GDP at present to 18% in 2050. Although the uncertainty surrounding these projections is substantial, there is broad agreement that these programmes need to be altered so as to curb their tendency to consume an increasing share of national income and make the promises they embody to the poor, elderly and infirm affordable. While the fiscal imbalance of Medicare and Medicaid dwarfs that of Social Security, the current policy debate is focused on reforming the latter, perhaps because it is arguably more amenable to a solution. Indeed, partly for demographic reasons, Social Security’s financial situation is less worrisome than that of most pay as you go systems in the OECD. Thus, a combination of adjustments to programme parameters could eliminate its current actuarial imbalance in a manner that it will not resurface over time by: Speeding up the transition from 65 to 67 for the age at which full benefits are paid and indexing it to increases in longevity thereafter. Moreover, increasing the early retirement age from 62 to 64 and raising the financial penalty to taking early retirement and incentives to delaying exit beyond merely actuarially neutral amounts would stimulate participation in the labour market, thereby expanding the tax base and improving retirement incomes.
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Reducing replacement rates for higher earners. These reductions might be calibrated so as to offset the effect of their above average gains in life expectancy on expected lifetime benefits.
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Reversing the rise in the share of earnings not subject to Social Security tax by increasing the taxable maximum, though this would engender some negative effects on incentives to work.
The addition of personal accounts would increase the pre-funding of Social Security only to the extent that they would be financed out of new saving. If such accounts were financed out of existing payroll taxes, pre-funding would arise only to the extent that the resulting higher ex-ante explicit government deficit would lead through the political process to a lower path for government current expenditures than otherwise. Moreover, because higher average returns in such accounts would be associated with greater market risks, eroding the existing defined benefit structure beyond what is necessary to put it on a sustainable footing should be avoided. Increasing participation in existing defined contribution plans outside Social Security, for example through automatic enrolment in employer-sponsored plans or a refundable saver’s credit for low income households, would be a more effective means to raise retirement savings among those mainly lower income groups that currently appear to provide insufficiently for their retirement.
The complexity of the personal and corporate income taxes has steadily increased since the last major tax reform in 1986, largely due to the continued proliferation of deductions, exemptions, credits and tax shelters that have substantially narrowed the tax base and created many distortions, several of which harm incentives to save. The Administration has charged an advisory panel with submitting options for federal tax reform with the aim of making the tax code simpler, fairer and more conducive to economic growth. A number of measures should be undertaken, even if the basic structure of the current income tax is retained:
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The deductibility of interest on home equity loans (which are for consumption purposes) should be eliminated. The deductibility of interest on loans for the purchase, construction or improvement of houses should be limited to a much lower threshold and eventually phased out.
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The exclusion of employer provided health insurance premiums should be capped. The deductibility on federal tax returns of state and local tax payments and the exemption of interest on public purpose state and local government debt should be dropped.
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A more wide ranging simplification of the personal and corporate income taxes with substantial base broadening and reduction in marginal rates as well as improved integration of corporate and personal income taxes would likely have substantial beneficial effects. The negative income tax for low income workers (EITC) should be maintained, as should the current preferential treatment of major forms of retirement saving, even though its effect on household saving may be limited.
Beyond these reforms, further efficiency gains might be obtained through greater reliance on consumption taxation. The replacement of the grossly inefficient corporate income tax by a federal VAT should be considered. With a broad base, such a VAT would probably raise enough revenue to reduce reliance on income tax revenues and exempt an even larger share of the population from paying federal income tax; at the same time, retaining a personal income tax would allow the desired degree of progressivity of the overall tax system to be achieved. In addition, if states changed their own sales taxes to a VAT, jointly administered federal and state VATs could lead to substantial efficiency gains for economic decisions and tax compliance and administration.
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Return to the Economic Survey of the United States 2005
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For further information please contact the United States Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Hannes Suppanz and Thomas Laubach under the supervision of Peter Jarrett.
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