David G. Tuerc

A fair solution to the budget crisis

By David G. Tuerck
July 19, 2011

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NEGOTIATIONS OVER the federal debt limit are stalled over whether to provide for spending cuts alone or to combine spending cuts with revenue increases. Just as Democrats think that fairness requires revenue increases, Republicans think they must stand fast against such increases in order to protect the economy from further decline. But there is a way to cut spending and increase revenues while stimulating the economy - by junking the entire federal tax code and putting a consumption tax in its place.

There are few principles on which economists agree, but one is that taxes on income discriminate against saving, whereas taxes on consumption do not. Because saving is necessary to fuel investment and, with it, economic growth and job creation, the replacement of existing income and payroll taxes with a consumption tax would provide the economic stimulus that everyone wants. And because consumption is less volatile than income over the course of the economic cycle, a consumption tax would reduce the vulnerability of the federal budget to deficits of the kind that we have suffered over the last three years.

Consider the proposed FairTax. It would replace all federal income and payroll taxes with a single tax on consumption. The tax would be set at 23 percent of the “tax-inclusive’’ price of every consumer good.

In order to make the tax truly “fair,’’ the law would provide every household with a monthly check equal to the tax it would pay if its income were at the poverty level. This “prebate’’ feature helps to make sure that the tax burden would be lowest on households that spend the least and highest on households that spend the most.

In 2010, the revenues from taxes that the FairTax would replace came to $1.975 trillion. But suppose that Congress had replaced those taxes with the FairTax. The government would have collected $2.188 trillion in FairTax revenue, $213 billion more than it actually collected from existing sources.

How would this miracle have been possible? Because consumption taxes typically yield more revenue than other taxes during downturns, the FairTax would have automatically cushioned the deficit against the downturn still under way last year. And that’s not all. Because the FairTax would bring about a rise in production and job creation by stimulating investment, it would it yield even more impressive revenue enhancements in the future. And this, in turn, would yield further reductions in the deficit and make it easier to avoid further cuts in spending.

By agreeing to adopt the FairTax now, the president and congressional Democrats could say that they considered spending cuts only after finding a way to increase revenues. And congressional Republicans could say that they got spending cuts only by accepting a revenue increase that benefited the economy. Progressives and Tea Partiers alike would be accommodated, the crisis over the debt ceiling would pass, and the economy would grow.

Fundamental tax reform seems to be temporarily off the table because of the debt ceiling crisis. But, in fact, one form of fundamental tax reform presents itself as the solution to that crisis. The FairTax commands broad grassroots support and offers the political cover that the president and Congress need in order to come to agreement. The idea is sitting there, just waiting for someone to see the obvious and take credit for it.

David G. Tuerck is executive director of the Beacon Hill Institute and chairman and professor of economics at Suffolk University.