For drama, it might seem difficult to top the past couple of weeks on Capitol Hill, but the debt ceiling debate in the United States is really only the opening act of a long-running production. The Obama administration and Congress will eventually have to agree to some watered-down measures that will enable an increase to the debt ceiling, to ensure that the country’s creditors continue to be paid on time. However, the necessary deal between the White House and House Republicans will be a political deal. It will only put off the tough economic and policy decisions to another act of this drama.
The fundamental problem facing the U.S. federal government is bringing taxes and spending into balance over the long run. Even if sustained growth is fully restored, Washington will be taking in the equivalent of 15% of gross domestic product as revenue, but spending 20% of GDP. If the budget is ever to be rebalanced, the U.S. federal government will have to tackle structural factors.
The United States is currently spending about 5% of GDP on defence and homeland security, compared with around 3% before 9/11. Social Security — long the “third rail” of U.S. politics — has a huge unfunded liability, and aging demographics will have a major impact on other social spending entitlements if unchecked. Yet, large cuts to defence and social spending are unlikely to be enough. Increases in taxes, combined with fundamental program redesign and a reduction in benefits, will eventually be required.
The medium-term fiscal plans brought forward by Republicans and by the White House currently fall well short of fiscal sustainability. The Republicans are ready to slash spending but unwilling to consider tax increases, while the Obama plan relies too much on sustained economic growth to reduce future deficits. A third option, from a President-appointed bipartisan panel, proposed a broad mix of spending cuts and revenue measures, but there has been little political takeup so far. Initially, tax hikes will affect wealthy Americans. But there is a limit to how much tax revenue can be raised by hammering rich people. At some point, tax reform will have to hit the broad swath of Americans. Some of the targets could include the elimination of popular but costly incentives such as deductibility of mortgage interest payments. Even these measures, however, will probably still fall short. Eventually, we expect the United States will have to do what Canada and other rich countries have done — implement a value-added sales tax.
Republicans, and even some Democrats, may well threaten to fight to the last breath before ever agreeing to it, but the merits of a sales tax are unmistakeable: It provides stable revenues, it affects almost all of the population, and it has the least impact on business investment. And as Canada found out in the 1990s, a value-added tax is a prolific generator of revenue, which the United States desperately needs.
The United States may already be in the midst of a “lost decade” due to the 2008 financial crisis, and the debt ceiling debate — suspenseful though it is — could be but a prelude to something much more dramatic. If international and domestic bondholders ever decide to stop buying new U.S. government bonds to fund the chronic fiscal deficits, the politicians won’t have much choice. The hard laws of economics will eventually force even the United States to face fiscal reality.
Canadians have a lot riding on the outcome of the current debate, due to our deeply integrated economies. As the U.S. goes through a difficult period fiscally and economically, Canadian businesses must re-double their efforts to adapt, innovate, diversify their sales, and internationalize their business model if they are to remain globally competitive. But Canada must also remain fiscally responsible to help offset the potential shocks ahead, so that a lost decade for the United States does not become a lost decade for Canada as well.
Glen Hodgson is senior vice-president and chief economist of the Conference Board of Canada. Kip Beckman is principal economist at the Conference Board of Canada.