Reducing the US deficit will mean pain for the middle classes

The writer is director of economic policy studies at the American Enterprise Institute

After years of pandemic spending, both US political parties are refocusing on the budget deficit. Republicans blame last year’s American Rescue Plan for today’s troubling inflation. Democrats by and large dispute this, but Joe Biden is touting his deficit reduction measures and championing long-term fiscal responsibility.

This represents a welcome turn in US politics. However candour about the long-term fiscal imbalance should be coupled with honesty about the solution: the middle class will bear much of the burden of stabilising budget deficits and the national debt.

Of course, neither political party would have you believe that. There is bipartisan agreement in Washington that the middle class should not face tax increases or spending cuts. Republicans don’t want to hike taxes, and the White House has repeatedly promised that its deficit-reduction plans will not increase taxation on those earning less than $400,000. In its populist incarnation, the GOP has abandoned any pretence of wanting to reduce spending on Social Security and Medicare, the middle-class entitlement programmes. Democrats have long opposed such cuts.

Deficits and debt are on an upward, unsustainable trajectory. The year before the 2008 financial crisis, the national debt was roughly one-third of annual economic output. By 2012, the debt-to-GDP ratio had exceeded two-thirds. As a share of GDP, the non-partisan Congressional Budget Office expects the deficit to be 6.1 per cent and the debt to be 109.6 per cent by 2032.

This situation can’t be fully remedied by cutting spending on low-income households. In 2019, before the pandemic, around one quarter of (non-interest) spending went to safety net programmes such as housing, nutrition, energy assistance, cash welfare and healthcare. That would have been enough to balance the budget in that year, but doing so would have left only 10 cents on the dollar for financially-vulnerable households.

More importantly, spending on the entitlement programmes that benefit the middle classes is projected to grow rapidly. Due to rising healthcare costs and the ageing population, the CBO expects Medicare and Social Security spending to increase by 56 per cent over the next three decades. This is expected to dwarf the projected increase in spending on the healthcare portion of the safety net. The remainder of federal spending — including other safety net programmes — is expected to decline as a share of annual economic output over this period.

Increasing taxes on the well-off would also fail to put the federal budget on stable footing. The non-partisan Committee for a Responsible Federal Budget estimates that repealing the 2017 tax cuts for high earners, increasing taxes on capital income and imposing a 5 per cent surtax on incomes above $10mn and 8 per cent on incomes above $25mn would still leave the debt on an unsustainable path. According to their forecasts, it would grow by around 80 per cent from 2032 to 2050.

Biden is focusing on people with incomes above $400,000 per year, less than 2 per cent of all tax filers. According to my estimates, increasing the tax rate on this group to a politically infeasible 95 per cent would generate an additional $421bn of tax revenue in 2022. This would reduce the primary deficit by 74 per cent. But since the deficit is projected to increase faster than the overall economy, even a tax rate this aggressively high would reduce the primary deficit by less than one-half by the end of the decade and by around one-third in 2050. The debt would still be growing, not shrinking.

In reality, such a high rate would lead to less work, fewer savings, more tax evasion and avoidance as well as an exodus of high earners — and substantially less revenue than I estimated. Raising the rate on income above $400,000 to 60 per cent would have relatively fewer behavioural effects, but still wouldn’t solve the problem: the primary deficit would be 19 per cent lower in 2032 and 14 per cent lower in 2050 with this rate, according to my calculations.

Ever-higher debt and deficits are a threat to long-term economic growth, wage growth and living standards. Ever-growing interest payments will reduce the political space for investments in infrastructure, basic research and upward economic mobility. If anything, politicians will make the problem worse, not better. Democrats continue to propose spending initiatives and if they return to power, Republicans will probably attempt to reduce tax revenue.

This threat can be addressed, but there simply is not enough revenue held by the top 2 per cent or enough spending on low-income households to correct the nation’s long-term fiscal imbalance. The middle classes will have to bear much of the burden — a reality that US elected leaders are reluctant to face.