If the U.S. is going to spend like Europe, Americans will get taxed like Europeans

Sounds like a catastrophe in the making. Yet neither the Biden administration nor Congressional lawmakers on either side of the aisle are advancing a blueprint to put America’s finances on a sound footing. What we’re getting this year instead is a spending agenda of never-before-seen scale, encompassing the $1.9 trillion American Rescue Plan signed into law in March, and the new president’s proposals for another $4 trillion-plus in new outlays for infrastructure and extra stimulus. The flood of new outlays enacted and in the wings comes after we’ve added $4.8 trillion in new debt since the close of 2019––a jump of almost 30% in the total burden.

Even before the pandemic struck, the U.S. was running gigantic, recurring deficits in the $1 trillion a year range, shortfalls that needed tackling to prevent rising interest expense from swamping future budgets. It’s reasonable to forecast that Congress will do little or nothing to reform outlays for Medicare, Medicaid, Social Security and other entitlements through 2030. So if spending remains on its current trajectory, what’s left for lawmakers to determine is the future of taxes. On that front, the U.S. could choose between two major courses of action.

The first is to raise taxes only to pay for the two Biden “infrastructure” plans, including part two for “human infrastructure,” and let the gulf between outlays and revenues grow year after year. The second: Greatly raise revenues to shrink the deficit. An excellent outcome would be achieving a shortfall of 2% percent of GDP by the end of the FY 2030, a level that, if maintained in subsequent years, would keep the U.S. out of danger.

Of course, a third scenario is also possible. If the U.S. simply lets spending run and doesn’t raise revenues beyond what’s required to fund the Biden platform so that deficits and debt explode, America’s financial foundation would become so fragile that it could be toppled by a recession, a pandemic or a war. If a calamity strikes, foreign investors could refuse to lend us the, say, $10 trillion needed to roll over our debt. Interest rates would spike, making more heavy borrowing ruinously expensive.

A gigantic tax increase would be the only solution. As economist John Cochrane of Stanford’s Hoover Institution observes, a government that’s become dependent on furnishing corporate bailouts and stimulus checks to get through tough times couldn’t borrow to stimulate. A sudden storm that strikes when we’re running huge deficits would unleash what Cochrane calls “the mother of all crises.”

Whatever the timing, the U.S. is moving inexorably towards a future of far higher taxes. And the middle class will bear the brunt of the burden, because as the bank robber Willie Sutton used to say about his targets, “That’s where the money is.” As Cochrane puts it, “If you want a European welfare state, pass European taxes. But keep in mind, Europe finances its welfare state mainly by taxing the middle class.”

Staying on course courts big risks

Let’s say the U.S. adopts our first course. Lawmakers leave spending on its current path, and freeze taxes except for financing a portion of the Biden platform. Where would the U.S. financial profile stand in 2030?

It’s important to emphasize that the administration’s proposed tax increases only pay for part of the president’s program, and contribute nothing to offset the vast wave of spending to come. None of the $1.9 trillion stimulus of the American Rescue Plan is funded; the entire amount will be tacked on to the deficit. Biden proposes fully funding the $2.2 trillion American Jobs or “infrastructure” measure with an increase in the corporate income tax.

For the soon-to-come, “human infrastructure” proposal, the administration pledges to cover all of the reported $2 trillion in outlays by increasing sundry levies on wealthy individuals and high earners. The package takes aim at people making over $400,000 a year. It would hike the rate on income for Americans in that bracket and above, and tax capital gains at the same rate as regular income, a change that would almost double the levy for those $400,000-plus earners.

“Biden is using up his entire tax program that was needed for future spending that already far exceeded revenues to pay for new spending programs,” says Brian Riedl, a scholar at the conservative Manhattan Institute who recently testified before the House Financial Services Committee. “Nothing is left over to pay for the promises already made, when Social Security and Medicaid spending is growing exponentially.”

Put simply, Biden has proposed no new taxes to reduce the huge deficits already in the cards. The CBO presents a “baseline” for revenues and outlays every few months called “10-year budget projections”; the latest edition was released in February. The agency, however, is obliged to show only numbers based on “current law.” Those figures don’t display the full picture––how bad things really look––in part because the CBO must exclude taxes or outlays that are due to “sunset” but are bound to be renewed. Hence, it’s crucial to add those items in a fully realistic forecast, as the CBO does from time to time (though not in its most recent forecasts).

Relying on data from the Committee for a Responsible Federal Budget (CRFB), this writer incorporated those items. The analysis forecasts that the Trump tax cuts for the middle class enacted in 2017 but due to expire in 2025, are extended. The CBO’s official baseline is improbable in showing minimal increases in discretionary spending. So I followed the practice of the CRFB and the CBO’s alternative scenarios of adjusting the numbers so that they rise with GDP––making annual spending totals considerably higher. I also added the extra interest payments and debt over the nine years that are a legacy of the deficit-financed, $1.9 trillion stimulus bill signed by Biden on March 11.

Here’s where the numbers would stand for the fiscal year ended September 30, 2030. Spending in 2021 will be extremely distorted above past and future norms because of all the stimulus spending. So the best benchmark is the projection for 2022. Using the CBO’s baseline adjusted for the $1.9 trillion stimulus and for tax and revenue measures likely to be extended, total outlays, encompassing mandatory, discretionary and net interest, are on track to grow over those eight years from $5.05 trillion to $7.45 trillion, an increase of 48% or 5.0% annually. Revenues should lag significantly, going from $3.995 to $5.23 trillion, a rise of just 31% or 3.4% a year.

That gap may not sound huge, but over an eight-year span it makes a big difference in expanding deficits and borrowing. By 2030, total debt would reach $41 trillion, $17.5 trillion more than the projected total for 2022. Consider that at the end of fiscal year 2019, U.S. debt stood at $17.9 trillion. So the U.S. is on track to add as much to its borrowing from 2022 to 2039 as the total owed pre-COVID. America’s ratio of debt to GDP would go from 79% in 2019 and just over 100% in 2022 to a scary 130%. At that point, the U.S. would shoulder a higher load than France or Spain held before the pandemic struck, and equal Italy’s share.

Interest expense would more than triple to $885 billion, almost half the total take from payroll taxes. The deficit would reach 7% of GDP, or $2.22 trillion, meaning that the U.S. would be spending nearly half again as many dollars as it’s collecting. America’s fiscal position would continue to weaken from there. The CRFB posits that by failing to reform entitlements or substantially hike taxes, the U.S. would post deficits of 13% of GDP by 2040, and debt to GDP would exceed 180%. By pre-COVID standards, only Japan would be significantly more indebted.

Gigantic tax increases on the middle class

Clearly, the U.S. cannot allow our debt and deficits to mushroom to such unsustainable heights. So either cuts in entitlements or big tax increases, or a combination of both, will have to happen. The pain will be a lot greater if lawmakers wait until after 2030, and they just might get away with delaying the inevitable, or in Washington-speak, “kicking the can down the road.” Once the can becomes an oil drum, the kicking has to stop.

But let’s examine our second scenario to see where taxes must go if we’re to achieve a responsible path by 2030, in the absence of major reductions in spending. Our goal will be lowering the deficit from what would be 7% of GDP to just 2% by 2030. Getting there would provide three huge benefits. First, it would make our debt load much smaller than and shrink interest payments compared to the hands-off scenario. Second, because interest expense would be manageable, we’d have the latitude to float the extra debt needed to weather a crisis.

Third, the U.S. could sustain that relatively comfortable ratio so long as revenues and outlays grow at the same rate. Getting to the magic 2% could instill the discipline to make that happen.

The rub is that if the U.S. gets there strictly by increasing revenues, we’re going European on tax side. The objective: Reaching a shortfall of $635 billion in 2030, less than 30% of the figure in the previous scenario where middle class levies remain at current levels. Spending over the span from 2022 to 2030 would be around $130 billion lower in total, because as deficits would decline year over years, the debt would increase at a much slower pace, curbing interest payments. By 2030, those savings would bring spending to around $7.3 trillion.

Hence, revenues would need to reach $6.7 trillion to clasp the 2% prize. That’s a revenue increase from 2022 of $2.7 trillion or 68%. The U.S. workforce is expected to increase only 5% by the end of the decade, so the tax burden per working person would have to rise about 65% in total. Americans’ taxes would need to increase at a rate of around 6.5% annually, for all of those eight years. Of course, incomes would be significantly higher as well. But since national income is projected to grow at just 4% a year, Americans would face tax increases of 2.5% a year larger as their annual raises, sharply lowering take-home pay.

Approaching European levels of taxation

Keep in mind that Americans also pay plenty in state and local taxes. That number was $4 trillion last year. A good estimate for 2030 is $5.6 trillion. The $6.7 trillion in federal taxes plus the $5.6 trillion state and local levies gets us to $12.3 trillion at the end of the 2020s. That’s 39% of national income. The U.S. share would match the current percentages in Greece (39.4%), and approach those in Italy (42.4%), Sweden (44%), and France (46.2%).

Even after reaching those heights, the rise in entitlement costs would require more big increases, though not a big as those needed if huge deficits continued propelling interest costs.

So what does Europe’s tax system look like? “European countries typically have 50% top income tax rates versus our 37%; 40% payroll taxes to our less than 15%; and 20%-25% value-added taxes,” says Cochrane of the Hoover Institution.

Most of all, notes Cochrane, the European states get the vast bulk of their revenues from the middle class. The U.S., he says, will need to do the same if spending keeps romping that this unbridled rate. He says that on the revenue side, the best solution for the U.S. might be imposing a value-added tax, a European staple. Cochrane cautions that the VAT should replace income and payroll taxes, not be an additional levy. “Europe added the VAT and kept the others,” he says. “We shouldn’t do that. But the VAT is a very efficient, broad-based tax that raises lots of revenue without doing economic damage.”

As Cochrane acknowledges, the VAT is such a money-raising machine that deploying it would risk growing government even faster. But if we’re going to tax like Europeans, maybe we should collect like Europeans––and going with a VAT would mean doing as they do, squeezing the big bucks from the middle class that our political system’s big spenders avow to champion.