Four Steps to US Fiscal Health

Reshaping the US health-care system to focus on successful outcomes and quality of life, rather than on employing the newest and most expensive technology, is a challenge for which no one yet has a proven solution.

By Simon Johnson and James Kwak

The United States has a significant budget deficit, likely to be $1.3
trillion (10% of GDP) this year, and the long-term forecasts are worrying.
According to the Congressional Budget Office (CBO, the leading nonpartisan
experts), Social Security, together with Medicare, Medicaid, and other
health-care programs, will grow to consume almost all tax revenues by 2035.

The US can finance these deficits in the short term – in fact, interest rates
on US Treasuries have recently fallen to record low levels. But if there is no
serious effort at fiscal consolidation, serious trouble lies ahead, both for the
US and for the world economy. Thus, the US urgently needs to begin making four
serious changes.

The first is comprehensive tax reform aimed at aligning tax policy with
desirable economic incentives. In particular, the US should consider introducing
a value-added tax (VAT), widely used in other industrialized countries. By
levying a tax on consumption at each stage of the production chain, America
could reduce the overconsumption that helped feed the recent credit bubble,
encouraging savings and investment instead. To be sure, a simple VAT is
regressive, though it can be made progressive by combining it with a partial
rebate or by exempting necessities.

Moreover, the US should look hard at tax breaks that act like hidden spending
programs. One place to start is the tax deduction for interest payments on home
mortgages. The deduction is currently available on mortgages of up to $1
million, this forming a key component of America’s excessive incentives to buy
houses – a policy eschewed by most other industrialized countries.

The second change is carbon pricing, either by auctioning emissions
allocations or by taxing carbon directly, at rates that start low and rise over
the coming decades. Given large potential revenues – in 2008, the CBO estimated
that one proposal would yield $145 billion in 2012 and more in subsequent years
– it would make sense to dedicate a portion to cushioning the impact of higher
energy prices on the poor, while applying the rest to the fiscal balance.

Opponents argue that carbon pricing would hurt economic growth. But a recent
study commissioned by The Economist found that a carbon tax would increase both
government revenue and economic output – primarily by replacing existing,
inefficient energy subsidies.

The third change is a tax on the financial sector, in the form of a Financial
Activities Tax on profits and remuneration at big banks that enjoy implicit
government guarantees. The International Monetary Fund estimates that this form
of value-added tax could bring in between 0.5 and one percentage point of GDP in
revenue.

Such a tax, moreover, would aim to eliminate the funding advantage that large
banks enjoy over their smaller competitors, while limiting the incentive for big
banks to become even bigger. As the IMF argues, if applied across the G-20, a
Financial Activities Tax would help constrain the worst features of the
financial system and reduce the competitive distortions created by the
megabanks.

Finally, there is the issue of entitlement spending, which is mainly an issue
of health-care costs. According to the CBO’s alternative fiscal scenario, growth
in Social Security is comparatively modest, from 4.8% of GDP in 2010 to 6.2% in
2035. A relatively small change in the parameters of this program could lower
its future costs, as was done in the 1980’s. At the same time, however, the
relative cost of Medicare, Medicaid, and other health care programs will more
than double, from 4.5% to 10.9% of GDP.

There are two ways to reduce the government’s health-care outlays: reduce the
amount of health care the government buys, or reduce the cost of health care.
The simplest solution is to mandate that the government buy less health care –
by raising the eligibility age for Medicare, capping benefits for high-income
beneficiaries, and so on.

The problem with this approach is that Medicare is not particularly generous
to begin with. If the eligibility age were to increase, responsibility for
health care for many people would simply be dumped back onto their employers,
resulting in higher health-care costs for all working people. A better solution
is to figure out how to reduce health-care costs.

This year’s health-care reform legislation, the Affordable Care Act (ACA), is
a starting point. According to CBO data, the ACA will reduce the long-term
fiscal deficit by two percentage points of GDP per year. A top priority should
be to preserve and expand its cost-cutting provisions. Another obvious step to
consider is to phase out the tax exclusion for employer-sponsored health plans,
which would not only increase revenue, but also end the distorting effects of
employer subsidization of health care.

But efforts to tackle health-care costs continue to be hampered by widespread
reluctance to tackle sensitive issues, as epitomized by the “death panel”
tempest of a year ago. Reshaping the US health-care system to focus on
successful outcomes and quality of life, rather than on employing the newest and
most expensive technology, is a challenge for which no one yet has a proven
solution. It remains, more than any other single factor, the key to long-term
fiscal sustainability.

Simon Johnson is a professor at MIT Sloan and a senior fellow at the
Peterson Institute. James Kwak is an entrepreneur and a student at Yale Law
School. They are the authors of 13 Bankers: The Wall Street Takeover and The
Next Financial Meltdown.