Can Tax Receipts From the Rich Be Counted On for New Spending Programs?

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Medicare and Medicaid are rightly identified as the biggest programs threatening the United States’ long-term fiscal health.  Yet there is something peculiar about devoting so much attention to long-term deficits when spending so far exceeds revenues today.  Over the next ten years, the Congressional Budget Office (CBO) forecasts a doubling of net federal debt as a percentage of the economy – from 41% in 2008 to 82% in 2019.  Yet the portion of that increase attributable to Medicare and Medicaid’s “excess cost growth” – increases in per capita spending in excess of nominal gross domestic product (GDP) growth – is almost trivial.  Even if we are able to curb federal Medicare and Medicaid spending, the ballooning debt will still remain, and the nation will still face the question of how to pay for it all.

The picture is worse when the forecast window is even more immediate.  Over the course of the 2009 fiscal year, CBO expects the net federal debt to increase by an astonishing 16% of GDP.  While most analysts are quick to defend such profligacy as a necessary short-run response to the collapse in private sector demand, the interest expense associated with this one-year surge in debt will increase annual government outlays by roughly one-third of one percent of GDP.  The collapse in interest rates has thus far shielded the budget from this expense – gross outlays for debt service have actually declined by about 15% in 2009 – but the annual cost of servicing this one-year debt increase will eventually be roughly equal to one-and-one-half times the real amount spent on the National Institutes of Health (NIH).

So who will pay for all this debt? 

Defenders of the Administration are quick to note that only 60% of the year-over-year deficit increase is attributable to increased government spending.  However, the 40% attributable to a collapse in tax revenues is as much a function of the current U.S. tax policy as it is the economic downturn.  As the U.S. Treasury has increased its dependence on income from the nation’s top earners (who are not the same taxpayers from year to year), the volatility of federal revenues has only increased.

According to Internal Revenue Service data, the top 1% of taxpayers paid a record 40.2% of federal income taxes in 2007 and the top 5% accounted for over 60% of total income taxes paid.  While rhetoric about taxing the “wealthy” often leaves the erroneous impression of stability, research has found that the income of the top 5% of earners is over four times as volatile as the income of the median earner.  The income of the top 1% is over 10 times as volatile.  The reported rise in average U.S. income volatility over the past 30 years is explained entirely by the increased income volatility of earners in the top 5% of the distribution.

Only about one-third of the income of the top 1% comes from wages and salaries, the taxes on which are withheld each paycheck.  Most of the earnings from the top 1% come from capital gains and business income passed through from unincorporated businesses, which the IRS calls “nonwithheld income taxes.”  As seen in the Monthly Treasury Statement, it is this nonwithheld income (“other”) that has fallen most dramatically during 2009.  While withheld income taxes are down 10.4%, nonwithheld income taxes are off by over 31%.  As a point of comparison, payroll taxes, which are assessed on a broad tax base and have limited exposure to high-income earners, are only down by 0.4% in 2009.  Relying on the top tax bracket, which is subject to such volatile swings in growth, to sustain an ever-expanding group of programs, is therefore a very risky proposition.

Many politicians seek to finance the expansion of health care coverage by further increasing the federal government’s reliance on volatile incomes.  The President proposed reducing the itemized deductions available to taxpayers in the highest tax brackets.  The House of Representatives proposed an entirely new tax surcharge to be applied to the top 1% of taxpayers.  Rather than creating a predictable stream of revenue to match incremental outlays, such proposals would risk pushing tax policy further towards the creation of “public financial bubbles” that are pricked periodically and result in enormous new debt issuance to “clean up” after the fact.  As central banks have come to learn with respect to asset price bubbles, systemic stability is better served when policy guards against bubbles from developing in the first place.