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Commentary By Brian Riedl

If Americans Want European-Style Benefits, They'll Need to Accept European Taxes

Economics, Economics Tax & Budget, Tax & Budget

The recently enacted Tax Cut and Jobs Act brought tax relief to the vast majority of families, modernized business taxes, and is already raising wages for countless workers. But unless lawmakers address the elephant in the room — the impending explosion in Social Security and Medicare costs — budget deficits will soar to unsustainable levels. And, no, raising taxes on the rich won’t make up the difference. If the American middle class wants European-style entitlements, it will have to accept European-level taxes.

The nonpartisan Congressional Budget Office estimates that simply keeping today’s programs on autopilot would push federal spending from the long-term average of 20 percent of GDP to nearly 30 percent of GDP over the next 30 years. The main spending-driver — the retirement of 74 million baby boomers — will raise Social Security and Medicare costs by 4.5 percent of GDP over this period. This is in part because the typical new Medicare retiree will receive $3 in benefits for every $1 paid into the system. Rising health-care costs will add one percent of GDP to Medicaid, and normalizing interest rates will add perhaps three percent of GDP to the cost of servicing the national debt.

Who will pay for this? Surveys show virtually no support — within either party — for reining in Social Security and health programs driving spending upward. Popular calls to cut waste and foreign aid would save little money. Defense spending is already on pace to fall from 4.7 percent of GDP in 2010 to 2.7 percent a decade from now — not far above defense-stingy Europe’s two percent target.

That leaves substantial new taxes. But for whom? Americans strongly prefer addressing the long-term fiscal imbalance almost exclusively through new taxes on the rich. The heated debate over the Tax Cuts and Jobs Act revealed a near-obsessive focus on increasing—or at least maintaining — the progressivity of the federal tax code. Issues like economic growth, tax simplification, and even the size of the tax cuts were often overshadowed by the question of whether the rich would disproportionately benefit. And in the end, despite reports to the contrary, the new tax law actually increases the share of federal taxes paid by the rich.

The principle that tax legislation must always increase progressivity is not new. Virtually every major tax law of the past 40 years — whether raising, cutting, or merely reforming taxes — was followed by wealthy families paying a larger proportion of the tax burden. This has occurred even after adjusting for increased income inequality.

The heightened progressivity has mostly come through the income tax. Actual tax returns show that the top one percent and the top 20 percent pay average effective income tax rates of 23 percent and 16 percent, respectively — nearly the same as in 1979. Yet the average rate paid by middle-income families as fallen from 7.4 to 2.6 percent, and the bottom 40 percent collectively pay zero income tax.

Payroll taxes are flatter — roughly seven to nine percent of most families’ income — although that money theoretically prepays a (declining) portion of future Social Security and Medicare benefits.

Overall, the top quintile earns roughly half the pretax income, but pays 88 percent of all income taxes, and 69 percent of all combined federal taxes. This gives the U.S. the most progressive income and payroll taxes of all OECD nations, even adjusting for differences in income inequality.

If taxes must indeed rise by 10 percent of GDP — which in today’s economy equals roughly $2 trillion, or $15,000 per household — it will be virtually impossible to maintain this extreme level of tax progressivity.

Why? Because the after-tax income of the bottom 80 percent of families collectively exceeds that of the top 20 percent. And at a certain point, large tax increases would have to tap into that broader group. There simply are not enough wealthy families to fund a European-style welfare state by themselves, and many of them already pay marginal tax rates (combined income, payroll, and state) above 50 percent, which leaves less room for additional taxes.

Even confiscating all family income above $500,000 would theoretically add just four percent of GDP in revenues. Slightly more plausibly, doubling the 35 and 37 percent income tax brackets to 70 and 74 percent would raise just over one percent of GDP. Other proposals to raise taxes on investors, oil and gas producers, banks, and hedge-fund managers would collectively raise 0.3 percent of GDP.

The inescapable reality is that adopting European spending levels would require also adopting European tax policies that more broadly hit the middle class. European governments tax the rich more heavily than America does, yet Europe’s tax burden is flatter because it also slams the nonrich with high income and payroll taxes. Stratospheric spending leaves no alternative. 

Additionally, the typical European nation imposes a painful 20 percent value-added tax, which is essentially a national sales tax that raises roughly seven percent of GDP in revenue.

If the middle class wants European government benefits, it should prepare to pay for them. Raising taxes on the rich simply won’t cover the costs.

This piece originally appeared at The Hill


Brian M. Riedl is a senior fellow at the Manhattan Institute. Previously, he worked for six years as chief economist to Senator Rob Portman (R-OH) and as staff director of the Senate Finance Subcommittee on Fiscal Responsibility and Economic Growth. Follow him on Twitter here

This piece originally appeared in The Hill