CHAMPAIGN, Ill. - A combination of more federal revenue and less government spending is imperative in order to avoid pushing an already weak economy over the edge, warns a University of Illinois business professor.
Jon S. Davis, the head of the department of accountancy and the R.C. Evans Endowed Chair in Business at Illinois, says at least two significant changes need to be enacted by lawmakers: entitlement spending reform, and a careful recalibration of how much revenue the government raises through taxes.
"We're looking at a huge deficit, and we're getting to a place very quickly where it's unsustainable," Davis said. "We're also in a difficult situation with the economy. If the economy was doing really well right now, we could maybe grow our way out of these problems. But right now, that doesn't look like it's going to happen anytime soon. Things look stagnant in the U.S., and even China looks pretty gloomy right now. So the question is, what can we do? At the end of the day, we simply have to pay our way."
According to Davis, enacting changes now would ultimately be a lot less painful than "having our hand forced eight to 10 years from now."
"We can't continue to do what we've been doing," he said. "Things like pushing the retirement age back on Social Security has to be on the table."
On the tax side, although the government isn't raising nearly enough revenue, it has to be careful in a global economy about how it raises revenue, because countries compete against each other in a variety of ways for business, Davis says.
"Countries compete with infrastructure, with how well-educated their work force is, with tax systems and government regulations," he said. "In countries that are considered 'business-friendly,' they have all of those factors in their favor as well as a tax-friendly system. So that's something else we have to be mindful of."
According to Davis, the U.S. has one of the highest corporate tax rates among members in the Organisation for Economic Co-operation and Development.
"We're up around 35 percent, and the OECD median is 18 or 19 percent," he said. "So we're way too high on corporate taxes, and we need to come down if we want to stay competitive. The way we treat income earned offshore versus domestic income also is a little bit off relative to how the rest of the world works. While we have to make some changes to make us more competitive, what that means is that we're not going to be collecting as much revenue from the corporate side."
Davis contends that the U.S. needs to get rid of the tax on dividends and switch to an integrated tax system for both corporations and individuals - "which is how a lot of the rest of world does it," he says.
"That means there would be only one level of tax, not two," he said. "That double tax on dividends is distortionary and just gets in the way."
But that would also reduce tax revenue. To make up the difference, Davis says the government should increase rates somewhat on the regular income tax or eliminate deductions. The government should also reform the earned-income tax credit as well as beef-up the estate tax for the wealthy.
"If you look at our tax system right now, there are really three income tax-paying populations in the U.S.," he said. "The low-income, who don't really pay tax because they have the earned-income tax credit; the middle-income earners, who pay the bulk of the income tax; and the wealthy, for whom the income tax is effectively voluntary. In the current system the wealthy pay the estate tax, and not much else."
But the best tax reform plan might be to scrap the income tax entirely in favor of the alternate minimum tax, which would have a lower tax rate than the income tax as well as a broader base, Davis says.
"More is taxed, with fewer deductions," he said. "For example, the home mortgage interest deduction is limited under the alternate minimum tax. Putting everyone on the alternate minimum tax and walking away from the income tax is a quick fix. We get more revenue along with a simpler and fairer tax system."
But even that is still not enough, Davis says.
"We actually need more taxes. Jean Baptiste-Colbert, who served as minister of finance under Louis XIV, said, 'The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing.' What that suggests is that you have a lot of different taxes. You need a variety of taxes, and you can't load up on any one tax because when you do, it starts to distort people's behavior and you don't want to do that."
According to Davis, the best choice would be a value-added tax - a tax on consumption that effectively functions as a national sales tax at every level of production.
Almost every country in the world except the U.S. and Sub-Saharan Africa has a VAT, Davis says.
"When the IMF bails out a country, one of the first things they have a country do is implement a VAT," he said. "In the U.S., we need another source of revenue and the best choice is a VAT. Whether it will play politically is up in the air. But if it's done right - and I have no confidence that Washington can do it correctly - it's not distortionary and it encourages saving."
The downside is that it increases the cost of living for everyone, Davis says.
"If you measure quality of life in material goods purchased, it would have a negative effect upon that," he said. "But at the end of the day, we need the revenue."
Would letting the Bush tax cuts expire steer the U.S. away from the brink of insolvency?
"We really should let the Bush tax cuts expire," Davis said. "Not letting them expire is effectively a tax cut, and everybody who is pushing that is essentially pushing for a tax cut. And when you consider the deficit we have, the last thing we should be talking about is a tax cut."
Davis says implementing U.S. Rep. Paul Ryan's budget plan or President Obama's "Buffett Rule" wouldn't have much of an effect, either.
"I don't think that any of the plans that politicians are throwing around are worth anything," he said. "They're playing to their base, that's all. The 'Buffett Rule' especially doesn't hit too many people. It's politics, pure and simple. The likely outcome will be incremental and reactionary, and more kicking the can down the road, because that's where the incentives are."