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The fiscal response of the U.S. government to the Covid-19 pandemic has been massive, and appropriately so in light of the economic threat posed by the worldwide spread of the pernicious disease. Nevertheless, it is clear that the debt that will be accumulated while combatting this crisis will significantly increase federal budget deficits and the national debt. For example, the Congressional Budget Office (CBO, 2020a) estimated in January 2020 that the federal deficit would be $1.0 trillion in fiscal year 2020 (FY 2020, ending on September 30, 2020), which amounted to 4.6% of GDP. CBO further estimated that the deficit-to-GDP ratio would increase to 5.4% in FY 2030.
In the interim, Congress has passed numerous relief packages in response to the pandemic, including (1) the Coronavirus Preparedness and Response Supplemental Appropriations Act, which was enacted on March 6 and provided $8.3 billion primarily public health and vaccine development, (2) the Families First Coronavirus Response Act, which was enacted on March 18 and included $192 billion of additional spending, (3) the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was enacted on March 27 and included $1.8 trillion of spending increases and tax cuts, and (4) the Paycheck Protection Program and Health Care Enhancement Act, which was enacted on April 24 and includes $483 billion in spending. In addition, Congress is currently debating the nature of another round of relief spending and tax cuts. As a result of the first three items and other policy and economic changes including a dramatic fall in GDP of 5.6% between the fourth quarter of 2019 and the fourth quarter of 2020, the CBO (2020b) now estimates (as of September 2020) that the FY 2020 budget deficit will be $3.3 trillion or 16% of GDP, and will not return to its previous baseline levels until 2024.
The associated increases in the national debt held by the public are significant as well. In January 2020, CBO (2020a) estimated that the debt would increase from $16.8 trillion, or 79% of GDP, in FY 2019 to nearly $31.5 trillion, or nearly 100% of GDP, by FY 2030. By comparison, taking into account the fiscal measure described above as well as the pandemic-induced decline in GDP, CBO (2020b) estimated in September 2020 that the national debt will increase to $33.5 trillion in FY 2030, or 109% of GDP, considerably in excess of the previous high in the debt-to-GDP ratio of 106%, which occurred in 1946 after World War II.
Following the 1946 peak in the debt-to-GDP ratio, the debt-to-GDP ratio plummeted from 106% to 30% even as expenditures grew slightly faster than revenues from 1947 to 1981. This was the result of generally rapid GDP growth over that time period. Once the effects of the Covid-19 pandemic dissipate, calls to bring the federal budget into balance on an annual basis are likely to increase, with widespread disagreement on whether to do so by reducing spending or increasing taxes. Note that the appetite for such fiscal tightening varies considerably, especially since interest rates are at historic lows (Gale, 2020). Given that federal expenditures are currently projected to increase much more rapidly than tax revenues over the next three decades, such fiscal tightening will require a mix of spending cuts and tax increases that will certainly be politically difficult to implement. However, the key to reducing to debt-to-GDP ratio will be implementing fiscal policies that maintain strong GDP growth while holding the growth in the debt as close to zero as possible. Thus, any possible decreases in spending or increases in taxes should be chosen to maximize future GDP growth as much as possible given other political factors.
Tax revenues might be raised in a number of ways. The simplest and most conventional would be to raise both business and individual tax rates under the existing income tax, undoing some or all of the rate cuts enacted under the Tax Cuts and Jobs Act (TCJA) enacted in 2017, or leaving rates unchanged and instead enacting other reforms that would broaden income tax bases. A rather different and more sweeping approach would be to enact a new tax or taxes and use all, or more likely some, of the revenues to reduce the fiscal deficit and debt.
Three candidates are most often discussed. One is a national value-added tax (VAT), a consumption-based tax that is utilized by some 160 countries around the world. Numerous proposals for VATs have been made over the years, including by the U.S. Department of the Treasury (1984), McLure (1987), and Graetz (2014); however, at least thus far, the VAT seems to be anathema to most U.S. politicians. We have analyzed the effects of a VAT in Diamond and Zodrow (2013).
A second approach is a carbon tax, imposed on fossil fuels in proportion to their carbon content as a proxy for the emissions of carbon dioxide that will occur upon combustion of the fuels when they are used in the production of goods and services. The carbon tax has the advantage of raising revenues while reducing the carbon emissions that give rise to negative externalities. Numerous proposals for a national carbon tax have been made in the United States, including the “Baker-Shultz Carbon Dividends Plan” (Baker et al., 2017; Climate Leadership Council, 2018), which would replace existing and future environmental regulations with a carbon tax that would begin at $40 per ton, increase over time, and would be rebated on an equal per-capita basis. As detailed in Metcalf (2019) and Stavins (2019), the United States has some local and regional experience with cap-and-trade markets for emissions, and carbon pricing mechanisms, either in the form of carbon taxes or cap-and-trade systems, have also been used or are scheduled to be implemented in some 50 countries. We have analyzed the effects of a carbon tax in the United States in Diamond and Zodrow (2018, forthcoming).
The third approach is a wealth tax, an individual-level tax imposed on all or most forms of net wealth (assets less liabilities) above a typically fairly large exemption amount. A relatively small number of nations currently utilize a wealth tax, and such taxes were advocated by Senator Bernie Sanders and Senator Elizabeth Warren in the recent Democratic presidential primary. As discussed below, proponents of a wealth tax stress that in addition to raising revenue, the wealth tax has the advantage of reducing the income and wealth disparities that have grown in recent years. In this paper, we begin by discussing the basic features of wealth taxation, administrative concerns raised by the implementation of a new wealth tax, and the economic effects of wealth taxation. 1 We then turn to a description of the computable general equilibrium model we use to analyze the economic effects of a wealth tax, followed by a description of our simulation results. A final section summarizes the results and suggests directions for future research.
This study uses the Diamond-Zodrow model, a dynamic computable general equilibrium model copyrighted by Tax Policy Advisers, LLC, in which the authors have an ownership interest. The terms of this arrangement have been reviewed and approved by Rice University in accordance with its conflict of interest policies.
This paper, revised on September 11, 2020, extends an earlier analysis prepared for the Center for Freedom and Prosperity (CF&P) Foundation.
This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.