Are higher taxes inevitable?

Higher taxes, anyone?

After an era of falling taxes, the federal government may be getting close to a change in the other direction.

This isn't something that politicians have proposed or that the American public wants. And this threshold won't necessarily be crossed during President Obama's term in office. After all, he campaigned on a pledge to reduce taxes for 95 percent of Americans.

But fiscal-policy experts generally say the question is not whether US taxes will go higher, but when. Some say it's likely that Mr. Obama will at least begin the process of reversing America's tax cut trend. The reason: Federal deficits are on an unsustainable path, which could put the whole economy's vibrancy and stability at risk.

Warning signs have been clear for years

This "fiscal train wreck" scenario isn't new, of course. Just remember Ross Perot and the 1992 presidential campaign.

But the question of possible tax hikes has gained currency this summer for several reasons. Budget deficits are running at a record pace – $1.6 trillion for this fiscal year, up from $455 billion last year, the White House Office of Management and Budget said Tuesday – thanks to stimulus spending and a recession-related dive in tax revenues. Debate over proposed healthcare reforms has raised public concern about whether Obama is committed to getting the deficits under control. Meanwhile China, a key buyer of Treasury bonds, has been voicing louder concerns about the safety of the US government debt it holds.

"My guess is that at some point this administration and this Congress will have to take on tax reform," says Isabel Sawhill, a Brookings Institution specialist on fiscal policy. In the process, "some revenue raising ... will need to occur."

It's a difficult situation for Obama. He campaigned as a tax cutter and has started off as such – one-fourth of his $787 billion stimulus package comes in the form of tax breaks. His main pledge: no tax hikes for households earning less than $250,000 a year. "You will not see your taxes increased by a single dime," he told voters. "Not your income tax. Not your payroll tax. Not your capital gains tax."

Some of Obama's top economic officials recently said it's important to keep fiscal options open, and that "hard choices" will be required to bring down federal deficits. But then White House spokesman Robert Gibbs reaffirmed the president's no-tax pledge.

A crisis could be catalyst to higher taxes

In this climate, some policy analysts say it will be a crisis – such as a sharp drop in the dollar or a spike in interest rates – that prompts Washington to confront the fiscal challenge.

"I'm fairly confident that will happen. I just can't say when," says Eric Toder of the Tax Policy Center, a nonpartisan research group.

In the past, voters and politicians alike have proved adept at supporting unbalanced budgets. It's possible that the next few years will provide a final opportunity to delay the fiscal reckoning, before the tide of baby-boom retirements gathers force.

Treasury Secretary Timothy Geithner has defined fiscal sustainability as holding the national debt constant as a share of gross domestic product. He says that can be done by bringing annual budget deficits down to about 3 percent of GDP. That may not prove easy to do in the near term, however, let alone the longer run.

As the accompanying chart shows, federal deficits are on track to balloon because of an aging population, medical costs that are rising faster than GDP, and a related surge in the cost of interest payments on the national debt.

Key measure: Federal spending as a share of GDP

Economists measure America's fiscal health by comparing government spending with the overall GDP that supports it. They also look at the so-called "fiscal gap," now estimated at about 8 or 9 percent of GDP. This refers to the magnitude of spending cuts or tax hikes that would have to be enacted today and permanently, to avoid piling larger debts on future generations. Delay will tend to make the fiscal gap larger as a share of GDP.

Obama and his team have talked about confronting this long-term challenge but so far haven't offered concrete plans.

For reference, 9 percent of GDP roughly equals what today's income tax provides to the Treasury. No one's suggesting that the fiscal gap will be plugged in one step or that doubling income taxes is the right way to do it.

But that's the scale of the problem. Many experts say it requires serious restraint of medical spending and more tax revenue.

"There is no way that we can solve the problem just on the spending side alone," Ms. Sawhill says. "Nor can we solve it just by raising taxes on the top 5 percent [of earning households]."

Need for a deficit-reduction plan by 2011

Few economists advocate higher taxes right away, with the economy still struggling to get out of recession. But Secretary Geithner says the nation needs to have a credible deficit-reduction package in place by 2011, when he expects the economy to be on a growth path again.

Already, the Obama administration has been finding some revenue-side wiggle room. The president has moved to raise $33 billion in revenue from higher cigarette taxes. He's supportive of a cap-and-trade plan to reduce greenhouse-gas emissions, which in some versions could amount to an energy tax. And tax code tweaks might be used to pay for some of his proposed healthcare reforms.

Sawhill says the government could secure about $1 trillion a year in new revenue while leaving tax brackets the same – just by removing layers of credits, deductions, and loopholes. Many deductions are popular, though, and it would be politically risky to get too clever about the definition of a tax hike.

Would healthcare reform make deficits worse?

Healthcare reform has provided a wake-up call for Obama. One of his core goals is "bending the cost curve," or slowing the rate of medical inflation far into the future. But last month, one proposal that emerged as his team conferred with Congress would have extended insurance to more Americans without curbing costs.

The director of the Congressional Budget Office put it bluntly: Lawmakers so far are failing to bend the curve. Perhaps as a result, recent polls show the public growing more focused on the problem of federal deficits and taxes.

At the same time, it's becoming economically risky for Washington to ignore the coming fiscal crunch. A dollar or interest-rate crisis may not be on the immediate horizon, but economic stress in those areas could easily emerge.

Michael Cosgrove, a University of Dallas economist, expects interest rates to rise next year as the economy recovers and governments around the world compete for investors to fund their rising debt. This could prod Congress to make some revenue-boosting tax changes in 2011, he says, once lawmakers have navigated next year's elections. "What they do will probably be incremental in nature," Mr. Cosgrove predicts. But taxes would then be going up, not down.