Given increased global competition and our graying population, it is very important that our tax system not only encourage saving but also discourage harmful consumption. Too many behaviors that impose "negative externalities"—social costs that are not factored into the direct accounting figures—go untaxed. For instance, Humvee owners don't have to pay taxes for the environmental destruction wrought by their vehicles. Moreover, many of the indirect costs of the country's dependence on oil—such as the expense (including national-security expenses) of shipping oil from the Middle East, along with the damage it does to the environment— go untaxed. A more efficient tax system would discourage this waste, and provide incentives for more-productive investment.
Are our taxes sufficient? The fundamental requirement of any tax system is that it raise enough revenue to pay for government expenditures. Although it's defensible—and even desirable, given the stimulus effect—to run short-term budget deficits during an economic downturn, this borrowing should be offset by surpluses during the boom period that follows.
By this standard our tax system is a failure. Last year, in large part because of recent tax cuts, federal tax revenues as a percentage of GDP were lower than they have been at any time since the Eisenhower Administration, falling for the third straight year—an unprecedented occurrence when the economy is coming out of a recession and we are at war. Meanwhile, spending on government programs grew by nearly nine percent—more than the average growth rate during the 1990s. The result is the largest federal budget deficit in American history.
Meanwhile, the states are in a fiscal mess that stems from several factors: state tax cuts throughout the 1990s, increased spending on government programs, escalating health-care costs, and the dampening effects of the nationwide recession. But state deficits have been made worse by the fact that many state income taxes are tied to the federal tax code and thus rise and fall with federal taxes.
Neither the federal government nor state governments are doing enough to redress these structural deficits. In light of the inevitable expansion of public pension and health-care programs that will accompany the retirement of the Baby Boom generation, we should have been building up either government reserves or individual savings. Instead we have been allowing our personal savings to fall and have been cutting taxes and increasing spending, thereby locking ourselves into deficits for decades to come. This is like kicking a live grenade down the road—and then walking up to it and kicking it again.
What if we decided to fix the tax system, to make it fairer, more efficient, and sufficient to pay for government outlays?
Only four basic things can be taxed: total income (including earnings from investment and other sources), wages, consumption, and wealth. Currently the federal government heavily taxes earnings, both wages and total income, while state and local governments rely more on taxing spending and wealth (mainly in the form of real estate). Roughly three quarters of all taxes are raised from what people earn, and only 15 percent comes from what they spend.