How to Control the Debt Without Touching Taxes

President Obama secured the support of Republican leaders for his bipartisan commission to look at ways to reduce our long term debt, but the GOP insists that any solutions with tax increases will be dead on arrival. So what would a sensible budget reform plan look like if we refused to raise taxes? Or, for that matter, if we refused to cut spending, and only raised taxes?

Rudolph Penner, former director of the Congressional Budget Office under President Reagan, has answers. With a team of academics, business people and public administrators, he answered those two questions in a monster report from the National Academies Committee on the Fiscal Future of the United States. I spoke to Penner about his debt-busting plans and the politics of deficit reduction.

Penner targeted a public debt-to-GDP ratio of 60 percent by 2020. With the debt-GDP ratio racing out to 100 percent by 2022 -- and possibly doubling again in the following 20 years when boomer entitlements explode -- that means he needed to go at the budget with a scalpel and a sledgehammer: putting entitlements on a budget and slashing defense until wars become nearly impossible expenditures.

Our interview is here:

Your team first drew up a budget to reach your 2020 target with all spending changes, and no new taxes. So what would a responsible budget look like in 10 years if politicians refused to raise the tax burden on Americans?

The answer is you have to do some very, very dramatic things. We reduced the growth of Social Security to the level of benefits that could be financed by the payroll tax structure and moved the full retirement age by five years. We dramatically reduced replacement rates -- benefits to earnings late in life, although we didn't reduce anybody's benefits below the purchasing power [inflation index] except for the most affluent.

On health we chose to slow the rate of growth of health costs ... Not speaking for the committee I think the only way to do it is to put Medicare and Medicaid on a fixed budget. That would require vouchers based on income for Medicare that could vary by geography and health. In any case we're talking about something very severe. Then with all other speding, we squeezed defense so that they couldn't invest in new weapon systems but could retain their personnel. You could have minor foreign interventions but nothing on the scale of Iraq and Iran. On infrastructure and reserach we also clamped down on. These are the draconian changes on the spending side if you keep taxes where they are.

A lot of Republicans -- and some Democrats -- are calling for even more tax cuts across the board for extended periods of time. But this budget picture is dismal enough already. Did you consider what it would look like with even fewer taxes?

The thought of actually cutting the tax burden is really quite implausible.

Now tell me what a reformed budget would look like if politicians decided to keep spending stable and make all the reforms on the tax side.

At the other end of the spectrum, we said let's keep our promises to Medicare, Medicaid and Social Security while keeping the 60 percent debt-to-GDP figure. The tax increases are quite extraordinary.

We had two strategies for financing the package. We increased all rates proportionally -- including capital gains and the AMT -- until the top [marginal income tax] rate rose to 50 percent [from 35 percent, where it is today]. We did that for around 2020. At that point we introduce a VAT [value added tax, or consumption tax], first at one percent and growing to 8 percent by 2040. It had to grow fairly rapidly. For Social Security, we had to increase payroll taxes from 12.4 to almost 15 percent. And then we needed a surtax on top of all that. All this would take us from a total tax burden including state and local from below OECD average today to where by mid century we'd be considerably above average. Spun out to 2060 we'd be one of the highest tax burdens in the world right alongside Denmark and Sweden.

The other approach was to radically reform the tax system, getting rid of all tax expenditures [such as tax exclusions for employer health care and pension contributions ... see more here] like capping the employer health exclusion. It's really, really remarkable how much money you get back from tax expenditures, especially from capping the health exclusion. We could actually lower rates over time with that solution to the situation, while keeping the overall tax burden the same.

Why deficit reduction this so hard politically? Is it the current climate, or is that the things that need cutting are naturally politically intractable?I've been watching the political scene for 40 years now and it's never been worse. We could talk for a long time about the reasons for that. Whatever the cause, at this moment we're marching hellbent for fiscal crisis. If you want to know what happens in fiscal crisis, look at Ireland and Greece. There comes a point when you have no choice but to reform the budget. Ireland can try to inflate their way out of the problem. We have one of the shortest maturity of debt in the world, so if we start to inflate, interest rates go way up. 

You've argued that Obama's budget doesn't scare us enough about the debt. But he's running $1.6 trillion deficit next year. Surely he doesn't want to convince people that deficits are scary just yet, right?

A lot of people argue that's a conflict: that there's a conflict between a short term and a long run. But you can't deal with the long run until the recession is closer to being over. You don't want to hit incomes today, but you can pass a law today that makes the kind of Social Security changes we have in our book, and they would not be effective until 2012 and go into effect extremely gradually. You can do things with Medicare. I suppose in economic theory there are subtle problems if people are far-seeing and they see reductions in their benefits -- rational expectation economists would say they'd cut spending immediately. But I don't happen to think people are so far-seeing.

I would focus assistance on safety net programs like food stamps. The institutional arrangements at state and local level means they cut back more than they need to and I can see some assistance there, and I would pay for it. I wouldn't mind short-term stimulus. That said, there's this idea for a payroll tax holiday for businesses that employ more people. I think that will be a lot of wasted money -- subsidies for people they will be employed anyway. In any case, my bottom line is that I don't see a conflict between short and long term.