Health Care: The Real Fiscal Nightmare

While policy wonks slug it out over McCain and Obama's tax plans, a far bigger problem looms: rampaging medical costs

A heated discussion is taking place in the economic blogsphere over the rival tax plans of Presidential candidates Barack Obama and John McCain. Of course, the battle of rival tax blueprints has been in force ever since the two hopefuls sewed up their respective nominations, but a new round of fighting recently erupted. A number of important points have been made. But the fiscal policy dispute, while informative and fascinating, has focused too much on tax regimes and not enough on the real challenge: health care. When it comes to domestic, nonmilitary fiscal policy in the new millennium, everything is dwarfed by health care.

The initial salvo seems to have come from an article critical of Obama's tax proposals in The American, a publication of the American Enterprise Institute (AEI). The article's title: "The Folly of Obama's Tax Plan."

"Unfortunately, a close inspection of Obama's proposals reveals something disquieting: He would raise marginal tax rates for many middle-income taxpayers, a bad move for anyone seeking to promote economic growth," charge AEI scholars Alex Brill and Alan Viard. (Economists for Obama response here.)

Cherry-Picked Example

Greg Mankiw, a Harvard University economist and 2003-05 head of the Council of Economic Advisers under President Bush, posted a favorable link to the article on his blog. That prompted a swift response from a group of economists aligned with Obama. "The key point that Brill and Viard neglect to note or discuss is that even in their cherry-picked example, higher marginal tax rates bring along offsetting benefits to families with lower and middle incomes," posted econ4Obama.

Tyler Cowen, an economist at George Mason University and the best-known blogger of the dismal science, weighed in on his blog. So did blogger Brad DeLong, an economist at the University of California at Berkeley. Obama economic advisers Jason Furman and Austin Goolsbee stepped up with a long op-ed piece in The Wall Street Journal. Mankiw reacted to their arguments on his blog. And so on.

Nevertheless, despite considerable illumination, the blogsphere tax dispute doesn't seem very important. What does matter is health-care reform, and from that base, tax and budget policy flows. As Dean Baker, an economist and co-director of the Center for Economic & Policy Research in Washington, has repeatedly emphasized on his blog, "virtually the whole [government] debt story is due to projections of exploding health-care costs." (I would argue that the debt is being fueled by excessive military spending. Interest on that debt will not surpass the cost of entitlement spending, but it'll be damn close. Health care costs related to entitlement programs are exploding the debt because the government spent the tax revenue collected to fund these programs on other programs, mainly military or defense related, such as Star Wars or the expansion of the federal government with the creation of the Department of Homeland Security. Increased revenue collections from industries which have benefited from this debt would bring back the monies necessary to relieve the deficit and cover booming expenses. In a 15 trillion dollar economy with a tax burden of less than 20%, or 3 trillion dollars, do not try to convince me that we cannot afford universal healthcare for our workers. There are countries smaller than my spare bedroom who are able to achieve this basic goal.--java)

To be sure, the claim that Obama will substantially hike taxes on ordinary Americans, dampening incentives to work and invest, is nonsense. To a large extent, much of the debate revolves around semantics. Letting the Bush tax cuts expire for some high-income folks could be called a tax increase. But since the Bush-inspired tax cuts automatically expire at the end of 2010, it's hardly a question of "enacting" a new tax hike. It could just as easily be called a return to the tax regime of the 1990s, hardly a lost decade in economic terms.

The Richest Pay a Lower Rate

What about marginal tax rates? Bill Gross, the legendary bond trader and chief investment officer of mutual fund giant Pimco, got it right in his monthly newsletter penned a year ago. He was commenting on a common tactic among private equity buccaneers and hedge-fund gunslingers to treat their compensation as a return on capital subject to the top capital-gains rate of 15% rather than the ordinary income tax rate of 35%. "What pretense to assert, as did Kenneth Griffin, recipient last year of more than $1 billion in compensation as manager of the Citadel Investment Group, that 'the [current] income distribution has to stand. If the tax became too high, as a matter of principle I would not be working this hard.' Right…Far better to admit, as has Warren Buffett, that the tax rates of the wealthiest Americans average nearly 15%, while those of their salaried and therefore less incentivized assistants just outside their offices are nearly twice that."

The charge that Obama's tax plan is the largest increase since World War II doesn't hold up. For instance, Factcheck.org, the public policy Web site run by the Annenberg Public Policy Center at the University of Pennsylvania, looked at Obama's proposed tax change as a share of gross domestic product. Taking into account the Congressional Budget Office's projection that GDP will reach $16.7 trillion in 2011, Obama's changes would add up to six-tenths of 1% of GDP—the fifth-largest percentage increase enacted since 1943.

Len Burman, director of the Tax Policy Center in Washington, captured the key difference between the two candidates at a July 23 conference, Dueling Tax Plans: What Would McCain and Obama Do? "So the major themes of these two plans are, in the case of Senator McCain's plan, that the major emphasis is on economic efficiency—cuts in marginal tax rates, improves economic incentives," said Berman in his opening remarks. "In the case of Obama's plan, the goal is primarily to improve progressivity—to lower tax burdens on low-income people and raise them on higher-income people," he added. The rest is nuance.

That's a reasonable divide where voters can differ. My own tax code preference is for both candidates to eliminate much of the complexity embedded in their proposals and the current tax system. A good starting place is Ronald Reagan's 1986 tax-reform initiative that closed a number of loopholes, broadened the tax base, and eliminated the difference between taxes on wages and taxes on capital. Of course, an idea like that isn't going anywhere at this stage of the campaigns.

By 2040, 40% of GDP

But the tax arguments aren't emphasizing the elephant in the room: health-care costs. When it comes to fiscal policy, taxes are a subsidiary issue. The crucial long-term fiscal problem facing the U.S. and its aging population is health-care spending; what happens to taxes will largely be shaped by changes in the health insurance market. There are lots of numbers to focus on. But taken altogether, here is a key number when it comes to Medicare: Total Medicare spending was 2.7% of GDP in 2005. That figure is projected to swell to 11% of GDP by 2080. Everything flows from health care, from tax rates to budget deficits.

And Medicare is really part of a much bigger problem: Total health-care spending in the U.S. by both public and private sources is expected to expand from 16% of GDP to 40% of GDP in 2040.

The pressure to reform America's broken-down, balkanized health-care system isn't going to disappear. Indeed, the cries for change will only grow louder. In a competitive global economy, layoffs, restructurings, downsizings, reengineerings—pick your favorite euphemism—are a permanent part of management's toolkit. Globalization and free trade bring enormous benefits to the U.S. economy and society.

But they also bring job insecurity and earnings instability. It makes no sense that in our health-care system when workers lose their jobs, their families lose their health insurance. Business has also learned that health care is no longer a "fringe" benefit, but a growing expense. They'd much rather focus on burning the midnight oil on how to boost productivity rather than how to cut back on health benefits. And overall, the U.S. population isn't getting any younger.

The blueprint that matters is health-care reform. Follow that debate, and you'll come to grips with what really matters when it comes to taxes and budget deficits.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.