Obama Commission Presents First Ideas on How to End the U.S. Government Financial Disaster
In August 2010, we summarized an International Monetary Fund (IMF) report that concluded the U.S. is broke. Last week the Government Accountability Office (GAO) issued similar conclusions in its report on the Federal Government's Long-Term Fiscal Outlook.
The report concludes:
“GAO’s annual fall update of its long-term simulations underscores the need to address the long-term sustainability of the federal government’s fiscal policies. … With the passage of time the window to address the long-term challenge narrows and the magnitude of the required changes grows. The federal government faces long-term fiscal pressures that predate the economic downturn and are driven on the spending side largely by rising health care costs and an aging population. GAO’s simulations show continually increasing levels of debt that are unsustainable over the long-term. ...
The GAO does not provide suggestions as to how this unsustainable problem is to be fixed, other than noting:
“In February, the President established the bipartisan National Commission on Fiscal Responsibility and Reform to identify policies to change the fiscal path and stabilize the debt-to-GDP ratio. The Commission is required to vote on a final report containing a set of recommendations by December 1, 2010.”
On November 10, 2010, the co-chairs of the National Commission on Fiscal Responsibility published a 50-page draft report. The sweeping plan would reduce the country's deficits by making drastic changes to the tax code, Social Security and certain government spending. Affluent Americans will pay the most, and will incur the greatest benefit reductions under the proposed plan.
The draft report was produced by the commission’s co-chairs, former Clinton administration official Erskine Bowles and retired Senator Alan Simpson(R-WY). The report was not (yet) endorsed by the full 18-member bipartisan group. The fact that the co-chairs presented their draft without support from the full commission probably is an indication that the majority of commission members are unwilling to endorse these ideas.
The draft report starts with some frank comments on the need for action. These initial comments include:
“America cannot be great if we go broke. Our economy will not grow and our country will not be able to compete without a plan to get this crushing debt burden off our back….
The Problem Is Real –the Solution Is Painful –There’s No Easy Way Out –Everything Must Be On the Table –and Washington Must Lead. …
It Is Cruelly Wrong to Make Promises We Can’t Keep. Our country has tough choices to make. Without regard to party, we need to be willing to tell Americans the truth.”
Proposed Tax Changes
The plan proposes a reduction in individual income tax rates to three simplified brackets of 8 percent, 14 percent and 23 percent. In exchange, all tax deductions and credits (called “Tax Expenditures”) are eliminated. The net effect of these two changes would be a tax increase. The rate reductions are necessary to avoid tax rates providing too large of a disincentive for work and productivity.
The report acknowledges that some tax breaks, particularly those that benefit individuals in the lower income brackets, might be politically difficult to eliminate. For this reason, the report shows three alternative rate structures that would accommodate tax benefits such as the earned income tax credit (EITC) child credit and mortgage deduction being retained. In each of the three alternatives, personal tax brackets are reduced from six to three. The following table from the draft report summarizes these alternatives:
Individual Income Tax Rates Corporate Rate
Bottom Middle Top
Current Rates for 2010 10% 15% 25% 28% 33% 35% 35%
Scheduled Rates for 2011 15% 28% 31% 36% 36% 39.6% 35%
Eliminate all Tax Expenditures 8% 14% 23% 26%
Keep Child Tax Credit + EITC 9% 15% 24% 26%
Keep Child Tax Credit + EITC; Reform Mortgage, Health, and Retirement Benefits at 80% of Current Level and Switch to Territorial System 12% 20% 27% 27%
Keep Child Tax Credit, EITC, and Current Mortgage, Health and Retirement Benefits and Switch to Territorial System 13% 21% 28% 28%
The plan would also increase the gas tax by 15 cents a gallon. All options eliminate the alternative minimum tax (AMT) and treat capital gains and dividends as ordinary income.
The report notes that Tax Expenditures (largely itemized deductions) disproportionately benefit upper-income taxpayers, so their elimination is primarily a tax increase on those taxpayers.
As shown in the above table, corporate tax rates would also be cut. In exchange, most corporate preferences would be reduced or eliminated. The eliminated tax deductions would include (i) the last-in, first-out (LIFO) method of inventory accounting, (ii) tax incentives for the oil and gas industry, and (iii) the relatively-young domestic manufacturing deduction.
International companies would be taxed on a “territorial” basis similar to what many other countries use. This change would stop the current method of taxing profits only when foreign corporate earnings are brought to the U.S. This current practice encourages U.S. multinationals to keep profits offshore, rather than being invested in the U.S.
Proposed Spending Changes
About 75% of the deficit reduction would come on the spending side (including Social Security). The report proposes a number of Social Security changes that will disproportionately affect higher income and more affluent workers/retirees. Social Security would undergo the following changes:
1. A tax increase on upper-income earners and their employers by a gradual elimination of the cap (currently at $106,800) on Social Security taxable wages.
2. Decrease benefits paid to more affluent retirees.
3. Index retirement age for benefits based on life longevity. This option would increase the benefit age by one month every two years after it reaches 67 under current law, meaning the normal retirement age would reach 68 in about 2050 and 69 in about 2075.
4. Change the way that cost of living benefit increases are calculated.
5. Include newly hired state and local workers in Social Security after 2020.
The report also suggests spending changes outside of the Social Security area. Although this is a complicated area that is beyond the scope of this article, the largest changes involve:
1. Proposed healthcare spending changes
2. Changing the manner that cost of living increases are calculated for all government entitlements and retirement payments
3. Increase the contribution made by government workers towards their retirement benefits
4. Reduce farm subsidies by $3 billion per year
5. Eliminate in-school interest subsidies for student loans
When President Obama appointed this commission, Democratic leaders pledged to put the package to a congressional vote if the commission’s report was approved by 14 of 18 members by a deadline of December 1, 2010. This deadline and related vote will not occur. For example, the proposal was immediately criticized by current House Speaker Nancy Pelosi as being “simply unacceptable” because it involved too much spending cuts and not enough increased taxes. Although the draft report has practically no chance of being passed in its current form, it provides insights into the magnitude of changes that will be necessary, and serves as a starting point for the debate on this topic.
ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.