The Truth about Entitlements

November 22, 2010

Most Americans would be happier if the outlook for the budget could be taken care of without having to make major changes to entitlement programs.  Certainly, politicians would have it easier if this were the case.  Unfortunately, arithmetic and prudence imply a need to tackle entitlements, says Arnold Kling, an adjunct scholar with the Cato Institute.

Raising taxes on high earners (those in the top 1 percent of the income distribution) is not a reliable way to deal with the budget deficit.

  • Increasing the effective tax rate requires much more than just raising marginal rates because individuals have the opportunity to shift income into forms that are taxed at lower rates.
  • Structural reforms to the tax system could reduce the ability of high earners to shelter income, but only with adverse effects on capital accumulation, entrepreneurship and risk taking.
  • In any case, even doubling the effective tax rate on high earners would not make the budget problem disappear.

Broad-based tax increases, bringing rates in line with those seen in Europe, will only solve the budget problem if there is minimal response of labor supply.

  • However, there is notable evidence that higher taxes produce significant long-run reductions in hours spent engaging in market work, with households substituting home production for taxable labor.
  • Higher tax rates could result in a large loss in consumer well-being with little or no increase in government revenues.

Finally, it is true that we faced a higher ratio of debt to gross domestic product at the end of the Second World War.  However, our current position does not resemble that of 1945, when we could look forward to sharp declines in government spending and large primary surpluses.  Instead, the outlook over the next two decades is for increased spending and ever-widening primary deficits.  Certainly, if productivity growth greatly exceeds the 1.6 percent per year embedded in current projections, the prospects for the budget would be brighter.  However, it is most prudent to align our promised entitlement benefits to realistic projections, not to optimistic hopes, says Kling.

Source: Arnold Kling, "The Truth about Entitlements," Mercatus Center, November 2010.

For text:

http://mercatus.org/sites/default/files/publication/The%20Truth%20about%20Entitlements.Kling_.11.8.10.pdf

 

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