Many Americans breathed a sigh of relief in January after Congress avoided the fiscal cliff. They shouldn’t have. The $600 billion tax increase over 10 years weakened the recovery and did very little to address America’s dangerous long-term budget deficits and rising federal debt relative to GDP. To understand the source of our budget woes and determine a path forward, we must first confront four thorny truths.
The principal fiscal choice is about spending. We must ask ourselves how large we want our government to be, and what we want government to do. Politicians like to focus on discretionary spending in the budget wars, but the growth in our debt is not being driven by foreign assistance or public-broadcasting subsidies or defense. What we are facing is an entitlement crisis. It has been looming for decades, and is now approaching a catastrophic scale. Federal discretionary spending has declined as a share of GDP over the past 40 years, while entitlement spending has increased dramatically. The Congressional Budget Office projects that this pattern will continue in the coming decades.
The second truth is that, in cases in which consolidation is brought about by reducing government spending, fiscal restructurings around the world have successfully reduced and stabilized the debt-to- GDP ratio. Such examples lie in contrast to the U.S., where there is so little emphasis on spending restraint.
Third, if the U.S. chooses the path of revenue increases, today’s soak-the-rich approach will prove inadequate. Wealth redistribution is a small contributor, as the fiscal cliff resolution makes clear — tax increases on the well-off have a minimal effect on the deficit; the income tax is poorly equipped to raise much additional revenue. A less progressive tax system, with greater reliance on payroll and consumption taxes — as in other industrial economies with large public sectors — would be needed to do so.
Finally, we can preserve our social safety net without breaking the fiscal bank, but we must change our concept of entitlements. We must reduce Social Security’s unfunded liabilities by gradually increasing the age at which benefits can be collected, and slow benefit growth for better-off Americans. Medicare’s still-larger unfunded liabilities can also be reduced progressively by providing support for basic health coverage for lower-income seniors, with scaled-back subsidies for everyone else.
Republicans will need to be clear about the gradual reductions in Social Security and Medicare spending required to avoid large tax increases. And Democrats will have to be clear that all Americans will see substantial tax increases if there are no adjustments in entitlement spending. Then we can have real debate over the path forward.
–Glenn Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush.
This story is from the March 18, 2013 issue of Fortune.
