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Fiscal therapy: 12 framing facts and what they mean

The American economy is in great shape in many ways. Riding the cusp of an expansion that started in 2009, the stock market is up, consumer confidence is booming, and unemployment has fallen to historically low levels. But dig beneath the surface and trouble looms. America faces two distinct but related challenges that policymakers must address in the coming years if they hope to provide a brighter future for the nation and its people. The first challenge is rising government debt. Federal debt is already higher as a share of the economy than at any time in our history, except for a few years around World War II, when a massive military buildup required immense borrowing. Under current policies, debt will rise steadily to unprecedented levels over the next decade and to unsustainable levels over the next 30 years and beyond. Debt isn’t always bad—we’ve had good reasons to borrow in the past to fight recessions and finance investments. Nevertheless, if we don’t rein in the growing debt, it will slowly but surely make it harder to grow our economy, boost our living standards, respond to wars or recessions, address social needs, and maintain our role as a global leader.

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The increase in debt will be driven mainly by an aging population and rising health care costs that boost federal spending on Social Security, Medicare (for the elderly), and Medicaid (for some of the poor and elderly). In addition, tax revenues are not expected to grow very fast. Rising red ink is often described as just a spending problem, but it isn’t intrinsically a spending problem or a tax problem, any more than one side of the scissors does the cutting. It’s the imbalance between the two that creates rising debt. Addressing the debt challenge will require both slowing the spending trajectory and raising taxes. The second challenge is changing the way we tax and spend. The nation has increasingly split into a fractured society with groups separated by disparities in income, education, and opportunity. This growing divide is not only inequitable, it is outright wasteful, reducing opportunities for tens of millions of Americans. To make Americans more productive and expand opportunity, we need more public investment—in education, health, childcare, nutrition, public infrastructure, and scientific research. But public investments in these areas (other than health care) are slated to shrink as a share of the economy to their lowest levels in more than half a century. We need to improve the tax system and raise revenues to finance public investment, encourage growth, and distribute tax burdens fairly both within and across generations. What matters is not just the debt, but how we raise and spend the money. How and when we address these twin challenges will help determine the future we build for ourselves, our children, and future generations. How can we address our rising debt rather than bury ourselves in red ink? How can we invest wisely so our economy does not corrode? How can we refashion taxes and spending to best support opportunity and prosperity? Fiscal Therapy, by William G. Gale In Fiscal Therapy: Curing America’s Debt Addiction and Investing in the Future, I explore these issues and offer a plan to remedy the problems in ways that would help us build a stronger, fairer economy. The proposals have three core themes:

  • Control entitlement spending: The proposals would contain spending growth in Social Security, Medicare, and Medicaid while also preserving and enhancing the programs’ anti-poverty and social insurance roles.
  • Invest in the future: By stipulating major new public investment in human and physical capital, the proposals would boost the potential for Americans to lead productive lives.
  • Raise and reform taxes: The proposals would raise adequate revenue to pay for government spending in a fair and efficient manner.

If enacted, the plan would put debt on a stable course and would boost economic growth in several ways. By controlling the debt, it would release huge amounts of capital for private investment. Corporate tax changes would boost business investment. New resources for children, education, and the safety net would increase human capital and make workers more productive. Additional public infrastructure and research and development would generate efficiency and innovation. By helping the poor and taxing the rich, the proposals would reduce inequality, increase opportunity, raise economic mobility, and lift living standards for American households. The proposals are realistic and administratively feasible. They largely build off existing programs that have already proven achievable in the United States or around the world. The proposals and the underlying analysis rest on five guideposts: the primary role of evidence and facts; the role of values (I try to be explicit where I am invoking values); the need for both the private sector and the government to be part of the solution; the importance of considering taxes and spending jointly; and the need to focus on realistic solutions, rather than utopian visions. Through our tax and spending policies, we can expand our economy or let it wither; make society more equal, or less; expand opportunity or continue to let tens of millions of struggling families fend for themselves. We do not have to kill government in order to save it. The proposals in Fiscal Therapy offer a way to act responsibly, pay for the government that people want, and shape that government and the economy in ways that better serve us all. Below are 12 facts that inspire the analysis and proposals in Fiscal Therapy and provide guidance for framing the issues presented in the book. The first three set the stage; the rest address particular policy areas.

1. We are headed toward uncharted waters.

We’ve had episodes of high debt before, but until now, they have always been due to wars or economic downturns, and the debt buildups decreased rapidly relative to the size of the economy after the war or downturn ended. After World War II, for example, debt peaked at 106 percent of GDP in 1946, but fell to half that figure by 1956 as strong economic growth prevailed.

Now, however, we have debt that is equal to about 78 percent of GDP, and it is projected to rise, slowly and steadily, to 180 percent by 2050 and higher levels beyond that (Figure 1). These levels are not only higher than ever before, they are due to different factors.

Notably, the source of our rising debt isn’t a war or recession. Unlike in previous episodes, we can’t solve this problem by cutting defense, which is already a much smaller share of the economy than in the past. Nor can we “grow our way” out of the problem, as we did after World War II. This would require far higher rates of economic growth than we can reasonably expect to generate. We are already generating large deficits in a very strong economy, and deficits are expected to rise even if the economy continues to do well.

The source of our rising debt is a built-in and growing imbalance between taxes and spending. Consequently, we’ll need to make tough choices about which programs to cut and which taxes to raise. We don’t need to eliminate the debt or even balance the annual budget, we just need to bring debt down to a sustainable, stable level. A 2050 debt target of 60 percent of GDP would do that, but it would require significant cuts in federal spending and/or increases in federal revenues.

Figure 1. Historical and Projected Debt as a Share of GDP, 1970-2050

2. Most federal spending goes to one of four areas: Social Security, health care, defense, and net interest.

In order to think clearly about fiscal issues, it’s crucial to get a sense of where the money goes. Americans routinely mistake the relative size of controversial budget items—from foreign aid, to the salaries we pay members of Congress, to the subsidies we allot for public television. Many want to believe that if we can just eliminate the least popular items, we can rein in red ink without breaking a sweat. But the numbers show how wrong that is.

While the government runs thousands of programs, just four areas—Social Security, health care, defense, and interest payments on the debt—account for more than two-thirds of all spending currently and will cover an even larger share in the future (Figure 2). Defense spending is already low relative to the size of the economy and we don’t want to default on interest payments. That raises the importance of containing Social Security and Medicare. To address the challenge only by reducing spending, we would have to cut those programs so much that we’d essentially destroy them. So, we need to look for more revenue as well.

Figure 2. Composition of Federal Spending, 2018

3. Americans deplore red ink but oppose most of the policies that would fix the problem.

For policy reforms to be successful and sustainable, they must have ample public support. But public opinion is wildly inconsistent on this issue. While the deficit consistently appears in polls as an important economic issue, the public opposes almost all policies that would reduce long-term deficits. For example, although polls routinely show that people think about 40 percent of government spending is waste, support for spending cuts evaporates when people are asked about specific programs. In 2017, a Pew poll asked people about 14 budget items that, collectively, covered virtually all non-interest spending. In every area, more than half of respondents wanted to increase or maintain spending. The only area with even close to a third of respondents supporting cuts was foreign aid, which accounts for less than 1 percent of the budget. Support for cutting major programs was weak. Less than 10 percent thought we should cut Medicare or Social Security. The one deficit-closing policy with strong and consistent support over the years is raising taxes on high-income households and corporations.

4. Health care costs are highly skewed: the 5 percent of people with the highest bills account for half of all costs, while the 50 percent of patients with the lowest bills account for just 3 percent of overall costs.

Health care is the largest area of federal spending, and the United States spends substantially more of its income on health care than any other advanced country without always getting good value for the money. Cutting costs is one major priority for reform. However, most of the high health care spending in this country is driven by patients who face a significant medical procedure (like treatment for a heart attack), have a chronic condition (like hypertension or diabetes), or are in the last year of life. As a result, significant cost savings could come from reducing the incidence and severity of extremely expensive cases—for example, by paying medical providers based on outcomes rather than services rendered, or by setting prices for hospitals. Medicare, which provides health care for the elderly and accounts for 20 percent of all health care spending in the United States, can take the lead in changing medical care practice and costs. Getting the 50 percent of the population with the lowest costs to reduce costs further through mechanisms such as health savings accounts (HSAs) and high deductible insurance plans won’t save much money.

5. Medicaid and CHIP cover about 45 percent of young children in America.

A second major health care priority is increasing coverage and building off the successes of the Affordable Care Act (Figure 3). Government-sponsored programs such as Medicaid and the Children’s Health Insurance Program (CHIP) provide crucial health insurance coverage for a large share of Americans. Having health insurance improves people’s health and financial status, and it reduces death from preventable causes. Moreover, better health for any particular individual can lead to better health for others by reducing the spread of disease. Medicaid makes people more likely to use health services, reduces the chances of having unpaid medical bills and catastrophic out-of-pocket medical costs, reduces rates of depression, improves self-reported ratings of good health, and reduces the incidence of low-birthweight infants and infant mortality.

Providing health services to children is particularly important. Children enrolled in Medicaid or CHIP are more likely to have annual check-ups and flu shots, and less likely to have unmet medical needs. They’re more likely to complete high school and college, and less likely to participate in risky behavior. From a purely budgetary perspective, a significant portion of Medicaid spending pays off in the long run, because adults who were exposed to Medicaid as children generate higher tax receipts and lower EITC payments than observationally equivalent adults who were not. Expanding Medicaid and CHIP coverage to all poor households and all children should be a top priority, even when the goal is to address long-term deficits.

Figure 3. Uninsured Rate Before and After the Enactment of the Affordable Care Act

6. Social Security provides more than 90 percent of income for more than a third of the elderly and more than half of income for about two-thirds of the elderly.

Social Security is quite possibly the nation’s most popular federal program and is certainly one of the most successful, providing a crucial foundation of income every year for tens of millions of people, including retirees, surviving spouses, dependents, and the disabled. But the program is financially unsustainable as it’s now constituted—the number of people who receive benefits is expected to rise much faster than the number of workers paying into the system—making it a big part of our overall budget problem (Figure 4). With reserves that accumulated in previous years and annual payroll taxes, Social Security can pay, through 2034, all the benefits that workers earn and claim. After that, the reserves will be depleted, and projected revenues will only cover about three-quarters of the benefits to which workers are entitled, leaving the program with a significant shortfall. Besides creating a financially sustainable program, a key priority for reform is to preserve and enhance the social insurance and anti-poverty features of the program.

Figure 4. Ratio of Social Security Beneficiaries to Covered Workers, 1950-2095

7. Our social safety net has too many holes.

The most precious asset the nation has is its people, but we are leaving far too many behind. In addition to the Social Security, Disability Insurance, Medicare, and Medicaid programs discussed above, the federal government promotes economic security by providing a helping hand for those who face temporary or long-term hardship. These programs benefit adults and their children by reducing poverty, improving educational outcomes, raising future earnings, improving health, and reducing crime. However, we spend far less on such programs than do European countries. Bolstering these programs and investing further in children should be part of any fiscal reform package.

A particular problem is that participation rates of social safety net programs are extremely low. Only 23 percent of eligible families receive Temporary Assistance for Needy Families (TANF) benefits, while only a quarter of eligible households receive federal rental assistance, and only 16 percent of families eligible for energy assistance receive it. We could significantly help low-income households simply by ensuring that people receive all the benefits for which they qualify.

8. Net federal capital investment has been close to zero for the past 25 years.

One way the federal government helps promote economic activity is by investing in infrastructure such as highways, mass transit, aviation, and water resources. Better infrastructure allows for cheaper transportation and communication of goods, services, and ideas, and it can directly raise the productivity of businesses and individuals.

However, gross federal investment is now at its lowest share of GDP since 1947 and, after accounting for capital deprecation, net federal investment has almost vanished (Figure 5). Combined federal, state, and local government net investment in non-defense infrastructure is at its lowest level in more than six decades. In 2016, the American Society of Civil Engineers estimated that the country needed $10.8 trillion over 25 years to maintain and rebuild existing infrastructure and build new structures consistent with the demands of future populations. If that number is too large to comprehend, consider this instead: the situation is so bad that Domino’s has taken to investing in local road repair so its drivers can travel more safely. Clearly, the nation’s infrastructure badly needs repair and further development, and any fiscal reform package must greatly enhance investments in infrastructure.

Figure 5. Federal Investment and Non-Defense R&D as a Share of GDP

9. We have room to raise taxes on the rich.

Raising taxes on the rich is the right idea at the right time for several reasons. For starters, high-income households have experienced skyrocketing income over the past 40 years, but their average tax rate has remained relatively constant. In a progressive system, average tax rates should rise as income rises, so they’re due for an increase. Moreover, most of the benefits of growth in recent decades have gone to high-income households. To the extent that addressing our fiscal challenge translates to more growth in the future, much of the gain will accrue to high-income households, so they should pay for the benefit. In addition, raising taxes on high-income households is the only significant way to have them share in the burden of resolving our long-term fiscal problem.

Increasing taxes on the rich would not necessarily hurt economic growth. Research shows little correlation between how countries change their top income tax rate and how much their economies grow (Figure 6). Additionally, evidence shows that the level of taxes does not appear to have much impact on growth. U.S. historical data show huge shifts in taxes with virtually no observable shift in growth rates. Cross-country comparisons yield similar findings. Over the 1970–2015 period, taxes at all levels of government were much higher as a share of GDP on average in the other G7 countries than in the United States, yet real per capita annual growth was virtually identical in those countries and the United States.

The best way to raise taxes on the rich would be to close loopholes related to capital gains and to otherwise reduce their ability to avoid taxes. Only after broadening the base would it make sense to consider raising rates significantly. Raising rates without broadening the base would induce significant tax avoidance.

Figure 6. Change in Tax Rates and Growth, 1960-1964 to 2006-2010

10. More than 60 percent of farm income and sole proprietorship income is not reported to the government.

Tax avoidance is legal; tax evasion is not. When people don’t pay taxes that they owe, they are not just cheating the government, they are ripping off their neighbors. The amount of unpaid taxes that are legally due—the “tax gap”—is larger than most people realize. Detailed IRS studies, updated to 2017, imply that that year’s tax gap was about $535 billion. At 2.8 percent of GDP, the gap was about 80 percent as large as the deficit that year and 16 percent as large as federal revenues.

Evasion rates depend on the tax system’s administrative features. Compliance is highest when third parties report income to the government and withhold taxes, such as with wages. Compliance is lowest when there is no cross-party reporting of income and no taxes withheld, including, for example, the income from sole proprietorships, which alone accounts for almost 30 percent of the entire individual income tax underreporting tax gap (Figure 7).

If we collected every dollar of taxes that were owed across the system, our fiscal problems would be largely gone. That may be impossible, however, unless we’re willing to give the IRS more authority and resources to investigate tax fraud. At the very least, though, cutting IRS spending, as policymakers have done in recent years, is penny-wise and pound-foolish. Adequately funding the IRS to pursue tax enforcement would raise revenues and assure the public that the system isn’t rigged in favor of the wealthy.

Figure 7. Income Tax Gap and Misreporting by Major Income Type

11. Every major country except the United States has a value-added tax (VAT).

To solve the nation’s fiscal problem, we’ll need more revenue than we can get through reforming existing taxes. One of the most effective ways to raise revenue is to enact a consumption tax such as a VAT. Even though VATs are in place in more than 160 countries, America has never had a national broad-based consumption tax. VATs have much to offer. Most important, they raise money. When asked why he robbed banks, Willie Sutton supposedly said, “because that’s where the money is.” In tax reform, VATs are where the money is. In OECD countries other than the United States, VATs are the third largest revenue source, behind income and payroll taxes. VATs are more conducive to economic growth than income taxes and easier to enforce than retail sales taxes. Critics argue that a federal VAT could hurt low-income households, small businesses, the elderly, and state and local governments. But these concerns are either overblown or easily addressed.

So, why don’t we have a VAT? Harvard economist Larry Summers once quipped that the reason was that “liberals think it’s regressive and conservatives think it is a money machine,” predicting that we would get a VAT when each side makes the realization that the other one has. Summers’ quote accurately describes how many people feel about the VAT, but there is no reason why the tax can’t be coupled with other policies to create a progressive package, or why it would have to be a money machine if it were part of an overall budget package.

12. Providing every coal worker in the United States a severance payment of $250,000 to compensate for losses associated with a carbon tax would cost less than 1 percent of the 10-year revenue gain from implementing the tax.

The United States should adopt a carbon tax. This would reduce future debt, correct a major inefficiency in the economy (the underpricing of carbon emissions), reduce carbon emissions, cut pollution, fight global warming, improve health, reduce traffic congestion, raise investment in clean energy, and lead to fewer government regulations.

One concern is that pricing carbon will reinforce the coal industry’s declining employment over time; the number of workers fell by two-thirds between 1987 and 2017. Those job losses have damaged many communities, but the jobs are not coming back, as options including natural gas have made coal less attractive. Policymakers should provide transitional financial assistance for affected workers (as noted above) as well as for communities and industries to help them and to garner political support in Congress to enact a carbon tax. Fortunately, that assistance would require only a tiny share of the revenue from the tax.

The United States currently imposes very low taxes on fossil fuels relative to our European counterparts. For example, the average combined federal and state gasoline tax is about 16 times smaller than the effective rate for taxes on petroleum in other G7 countries and nine times smaller than those on diesel fuel. Several countries already have carbon taxes, and more nations will likely do so—especially if the United States takes the lead—to comply with recent global climate and emissions agreements. We have the room and the need for a carbon tax.

For details on revenue and spending calculations in Fiscal Therapy, see https://www.brookings.edu/FiscalTherapyCalculations.

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