Let’s Pay for the Government We Get

Why, someday soon, middle-class taxes will have to go up.

The conservative icon Milton Friedman once commented that “to spend is to tax,” since public debt and related interest must be repaid. Though conservatives today seem to have forgotten that fact, it provides an organizing theme for We Are Better Than This: How Government Should Spend Our Money, Edward D. Kleinbard’s thoughtful new book on the federal budget.

No one likes to pay taxes, and most taxes discourage something. So it makes little sense to consider the appropriate level of taxation without referring to the benefits of government spending funded with tax revenues. Accordingly, Kleinbard—the former staff director of Congress’s nonpartisan Joint Committee on Taxation—rests the case for higher federal tax revenues on a well-reasoned defense of federal spending.

Nov14-Kleinbard-Books
We are Better
Than This

by Edward D. Kleinbard
Oxford University Press, 540 pp.

He begins by debunking the idea that markets alone maximize public welfare. Even if one believes that market-related efficiencies tend to maximize national income (or gross domestic product), that measure of economic output does account for the value of programs—such as Social Security and food stamps—that reduce a citizen’s fear and despair when confronting potential destitution. Kleinbard quotes extensively from Adam Smith, the eighteenth-century patriarch of market economists, when emphasizing each individual’s connection to “the union of mankind.”

Enlightened public policy can moderate income inequality produced by a market system. In the last four decades the median inflation-adjusted taxable income of middle-class male workers has declined, while the amount and share of national income received by the top 1 percent of earners has soared. After reviewing studies that adjust taxable income to account for government benefits and taxes, Kleinbard notes that in recent decades most of the growth of standard of living by middle-class households has resulted in public benefits (including the value of group health insurance), lower taxes, and greater female participation in the workforce. He views that fact as a vindication of the government’s ability to ameliorate the trend of rising income inequality, while noting that the social safety net for more than a decade has relied on a “fiscal policy of borrowing against the future by delivering more transfer benefits than our current level of tax collections can support.”

The author pokes holes in the belief in a “growth fairy” that can miraculously erase the long-run burden of debt-financed tax cuts. Somewhat higher marginal tax rates do not cause people to quit work or work less, though there is some evidence that raising the rate for the highest bracket does effectively motivate greater tax planning that reduces or defers taxable income. Businesses are able to immediately deduct investment in human capital (worker training) and intangibles (branding, software, patents, and so on), and they can use debt and accelerated depreciation to rapidly deduct investment in machinery and equipment. The value of those incentives to invest goes up alongside higher rates of taxation of business income, a fact that explains the wariness of capital-intensive businesses to “tax reform” proposals that lower rates by reducing deductions.

Though Kleinbard acknowledges the need for reform of the taxation of capital income, his rigorous and thoughtful analysis of alternatives should frustrate both conservatives and liberals searching for a sound-bite solution. He accepts the economic criticism of double taxation of dividends and a corporate tax system that fails to account for the cost of equity. Accordingly, the author—a tax expert—favors a system that would eliminate the deduction of interest from business income while permitting firms to deduct a new standardized “cost of capital allowance.” Shareholders would be taxed based on this same standardized return, regardless of whether or not they received a dividend or capital gain. The book’s thorough analysis of capital taxation is alone worth the purchase price, though the sweeping reform it recommends may be more useful for illuminating flaws in the existing system than for shaping viable legislation.

Kleinbard shines light on the unintended consequences of overly simplistic policy prescriptions, such as efforts by House Republicans to cut funding for food stamps for the ostensible purpose of encouraging work. The existing food stamp program encourages upward mobility by reducing benefits only gradually as beneficiaries earn higher wages. That gradual phase-out, however, increases the number of eligible beneficiaries. (Another means-tested program with benefits that are reduced gradually with income, the Earned Income Tax Credit, provides an incentive to work that supplements the incentives embedded in food stamps.) While budget cutters can “save money” by confining benefits to households with only the lowest incomes, in doing so they would reduce incentives to work and earn more.

Kleinbard warns progressives against a knee-jerk opposition to broad-based taxation, which may be needed to sustain spending that disproportionately benefits people with lower incomes. While avoiding direct criticism of President Obama, he disagrees with the pledge to limit tax increases to households with incomes over $250,000 or the higher threshold of the top 1 percent.

The author’s comprehensive view of the net effect of spending and related taxation harks back to that of generations of progressives who believed in social insurance funded with a broad base of contributions. Franklin D. Roosevelt explicitly contrasted Social Security pensions and employer-financed unemployment insurance with programs he called “the dole.” The fact that citizens with low incomes may benefit from social insurance more than others—through pensions at a higher percent of low lifetime income and lower premiums for Medicare Part B—should not eliminate the distinction between “insurance” and “welfare.” After all, the families of those who die young or suffer from more acute illnesses receive greater value for each dollar of premium paid for life and medical insurance.

Progressives face a challenge in managing a transition from their defense of deficits used to sustain aggregate demand in response to the Great Recession and their defense of sustainable tax-financed spending today. Kleinbard’s book provides a timely context for that pivot. The Congressional Budget Office projects that gross annual debt service will rise from $425 billion in fiscal 2014 to $1.1 trillion in 2024. Soaring debt service will squeeze out domestic spending, apart from entitlements, which are projected to drop to the lowest share of national income in more than half a century. Domestic discretionary spending could plunge to zero if the budget is balanced at the level of taxation embodied in the compromise that kept us from falling off the January 2013 fiscal cliff.

That compromise widened the long-term gap between federal spending and federal revenue by limiting application of pre-2001 tax rates to the top 1 percent. Kleinbard likens this to throwing a boomerang rather than dodging a bullet—in this case, the boomerang returns to hit discretionary domestic spending, which includes federal investments in education, infrastructure, and scientific research. Some of his recommended tax policies, such as a limit on the value of tax deductions for those in higher brackets, would increase the progressivity of federal taxation. Yet he also advocates restoring pre-2001 income tax rates for brackets lower than the top 1 percent.

For almost two centuries the bipartisan goal of balancing the budget imposed pressure on elected officials to link their spending and tax policies. Even when those policies began to diverge in the Reagan administration, few elected officials in either party contested the ideal of a balanced budget. That popular goal created the political framework for bipartisan agreements to raise taxes during the Reagan administration after 1981 and to better align federal spending and revenues in 1990 and 1997. Since 2000, leaders in both parties have subordinated the ideal of balanced budgets to other policy goals, and routine borrowing now continues even as the smoke clears from the extraordinary borrowing used to finance two wars and the response to the Great Recession.

We Are Better Than This offers a comprehensive view of the federal budget. When congressional leaders in both political parties support levels of spending far higher than available tax revenue, it is no wonder that many voters take the benefits of spending for granted. Grover Norquist will sound reasonable as long as lower taxes have little discernible immediate impact on Medicare, national defense, or other salient federal benefits. Kleinbard’s message about the relationship between spending and tax policies will reach a larger audience when viable candidates—and not just analysts—take responsibility for reminding voters that we should, indeed, be better than this.

Bill White

Bill White , chairman of Lazard Houston, is the author of America's Fiscal Constitution: Its Triumph and Collapse. He was the mayor of Houston from 2004 to 2010 and the U.S. deputy secretary of energy from 1993 to 1995.