Could tax increases alone close the long-run fiscal gap?

Extraordinary fiscal recovery measures during the COVID-19 pandemic pushed U.S. public debt to levels rivaling its historic highs. Interest rates are significantly higher than they have been in over a decade. Many projections—including near-canonical graphs of debt as a share of gross domestic product (GDP) produced by the Congressional Budget Office—look extremely daunting, with debt ratios skyrocketing over the next few decades. In short, the benefits of measures to reduce budget deficits appear higher than they have in years.

However, without context, these presentations of debt can make the overall fiscal challenge look near-hopeless and create an environment where any measure to reduce debt seems necessary—no matter its other costs.

This post aims to do two things: (1) bring some context to the size of the policy adjustments needed to stabilize the U.S. debt-to-GDP ratio (or just debt ratio); and (2) compare the size of this policy adjustment with plausible efforts to stabilize the U.S. debt ratio using tax increases alone.

To stabilize the debt ratio at today’s level, we would need to either raise taxes or lower non-interest spending by 2.2% of GDP. This is eminently doable through tax increases alone, as our own historical past and the experience of other rich nations suggest. There may be political challenges to raising taxes, but there is very little reason economically to suggest this would be a bad way to solve the U.S. fiscal challenge. In fact, there are multiple advantages to using higher taxes as the preferred method of bringing down the deficit, particularly from a progressive perspective that centers equity.

Taxes permit a more targeted and equitable approach to minimizing the shortfall. A large majority of federal spending is highly progressive in its incidence, providing huge value to low- and moderate-income families (there are obvious exceptions to this rule, like defense spending, but defense spending currently constitutes a relatively small percentage of GDP compared with other expenditures). Given the value of current federal spending for meeting progressive goals, using taxes as the lever for making any needed reductions in budget deficits should be a priority in coming debates over debts and deficits.

The fiscal gap: A summary measure of the future debt challenge

The “fiscal gap” is a tool to quantify fiscal sustainability. It looks at the long-run stability of the debt ratio, measuring how much a government must reduce non-interest deficits in order to achieve and sustain a given target debt ratio.

The chosen target obviously matters a lot, with lower debt ratios requiring significantly larger changes in fiscal policy. For our purposes, we’ll use stabilization at today’s debt ratio as our base case—most experts would agree this is a useful starting point. Some might assume that level is too high, but there’s no serious evidence that any particular debt ratio causes substantially worse economic performance.

The fiscal gap that would stabilize the debt ratio at today’s value is roughly 2.2% of the U.S. GDP. Is that a lot? It’s higher than we would like it to be, all else equal, but it’s likely quite a bit lower than many might assume given how high budget deficits have been in recent years. To some, anything besides a budget surplus might sometimes seem like an unsustainable fiscal position. But that’s not right—even a relatively conservative outlook on the nation’s fiscal stance doesn’t demand a balanced budget.

To illustrate how the fiscal gap can be so manageable even though projected debt levels appear frighteningly high, imagine debt as the level of water in a bathtub. Water is flowing in from the top and draining from the bottom. Think of the fiscal gap as the rate at which water is coming from the faucet. Allowing water flow to increase too fast can overwhelm the ability of the drain to remove water and hence result in steadily rising water levels, causing the tub to eventually overflow. To extend the analogy, the effectiveness of the drain in keeping debt levels stable hinges on how low interest rates are and how high growth is. Low rates and fast growth allow lots of water to be removed from the debt tub. In recent decades, growth has exceeded interest rates, and hence any given flow of deficits (water coming into the tub) has not compounded rapidly into higher debt.

Yet for any given constellation of interest rates and growth, even a small reduction in the flow of water coming in can allow the drain to remove all of the incoming water, and the tub never overflows. In the same way, what’s most important is the size of the fiscal gap—or flow rate—as opposed to the magnitude of the overall debt—or total water in the bathtub—and how fast the drain is removing it.

The U.S. is a low-tax nation compared with international peers

Comparing the United States with its peers can provide some context. U.S. spending is middle of the pack in recent years due to its surge of COVID-19 relief spending, but trends on the lower end when looking at numbers before 2019. Similarly, U.S. revenue is abnormally low. Our revenue-to-GDP ratio was 31.5% in 2019, much lower than the average of 42.7% amongst peer countries. This places our revenue-to-GDP ratio at the second lowest out of 27 peer countries (and the lowest if you exclude the unusual case of Ireland). Note that the countries that collect more revenue relative to their GDP also tend to provide more government services than the U.S. In short, a country’s welfare state generosity hinges on how much they are able to raise in taxes. You can learn more about how the United States compares on the EPI Tax Explorer.

There are two obvious lessons here.

First, we’re an outlier in how small our fiscal footprint is. Compared with the rest of the world, we don’t tax and spend much. Given that public spending is a key way to reduce inequality and poverty, the small fiscal footprint of the U.S. means we haven’t invested much in poverty alleviation relative to our international peers.

Second, raising U.S. revenue levels to the average level of our peer countries would raise the equivalent of $2.61 trillion, roughly five times the amount needed to close the fiscal gap. Importantly, places like France and the Nordic countries collect this level of high revenue while still delivering reliable growth in living standards. These rich, high-functioning countries don’t seem hampered by excess taxation.

Our peer countries prove that high revenue levels are entirely possible, even though the U.S. revenue-to-GDP ratio does not need to get even close to the top of the revenue scale to close the fiscal gap. It’s worth noting that if we relied on just spending cuts to close projected fiscal gaps, this would just lock in our abnormally small fiscal footprint and our current stingy approach to poverty alleviation.

Now, suppose that we did raise exactly the amount of revenue needed to close the fiscal gap, or about $500 billion in revenue, and that we did this with just taxes. This would raise the U.S. revenue-to-GDP ratio to 32.4%. This does not shift the United States in its international ranking much. Increasing taxes by 2.2% still keeps the United States at the bottom, far from the thresholds set by most peer European countries.

The U.S. once had taxes high enough to close today’s fiscal gap

Of course, the U.S. isn’t France—are higher taxes possible here? Could 2.2% of GDP be raised without pushing U.S. taxation well outside its historic comfort zone? There are no current policy proposals to raise 2.2% of GDP in additional tax revenue, but it is certainly plausible from an economic point of view. Besides the evidence offered earlier from international comparisons, even our own not-so-distant economic history has shown that tax revenues high enough to close today’s fiscal gap were either actively being collected, or clearly would have been, if not for radical policy changes that cut tax rates.

For example, the Trump tax cuts are projected to cost approximately 0.7% of U.S. GDP annually on average over 10 years. The largest specific provisions decreased the corporate tax rate, and this provision alone caused revenue to fall by roughly 0.5% of GDP. And these were not even the biggest tax cuts in U.S. history—that title is taken by Reagan’s tax cuts.

We can perform a thought experiment by considering the tax revenue we would have raised if tax rates by income percentile had remained at pre-Reagan levels. These historical federal tax rates confirm that it would be possible to raise 2.2% of GDP in taxes.

The overall average federal tax rate in 2019 was three percentage points lower than in 1979, before Reagan tax cuts. This is unusual, in and of itself, because taxes across countries tend to increase as a share of GDP as per capita income rises. More importantly, though, this means that we’ve had taxes high enough to close today’s fiscal gap in the past; increasing taxes to generate 2.2% of GDP in revenue would not be anything unprecedented.

The fact that tax rates for all income groups are lower in the present day than in 1979 suggests that the series of tax cuts undertaken at various times since then cost us a critical sum of lost revenue. If we had kept tax rates stable at the 1979 level, we could have generated approximately an additional $532 billion in 2019. This is greater than the fiscal gap, suggesting that we could have closed the fiscal gap already.

Suppose, however, that we do not want to keep tax rates for all groups fixed at 1979 levels. For example, consider the counterfactual where we maintained the 1979 tax rates for all groups except the bottom quintile of households. This bottom quintile saw significant tax cuts between 1979 and 2019, and these tax cuts (with effective tax rates actually becoming negative in recent decades) stopped the issue of taxing households into poverty. Hence, it would make a lot of sense to protect the tax cuts that have happened for this group. Maintaining 1979 tax rates for all groups except the bottom fifth would still have yielded an additional $469 billion by 2019, which is approximately 95% of the fiscal gap.

A similar exercise can be done to see how much revenue could be raised if we had kept tax rates the same since 1979 for just the highest quintile of households. In this scenario, we could have generated an additional $261 billion—closing roughly half of the total fiscal gap.

In short, it took a series of large (and regressive) tax cuts over a series of decades in order to generate today’s fiscal gap. Absent these cuts, revenue was firmly on track to be high enough to keep the fiscal gap at near-zero. It hence seems reasonable to think that taxes alone could indeed close the fiscal gap without pushing U.S. tax rates out of any zone of plausibility.

How much taxes should come from the top households?

Besides keeping the tax rates for the highest-income households constant at 1979 levels, one could imagine even more progressive revenue options that might put a big dent in the fiscal gap. For example, a 5% surtax has occasionally popped up in policy debates, including in early versions of the Affordable Care Act. In a counterfactual world where we kept tax rates for the top 1% at 1979 levels and then levied a 5% surtax, we could have generated $293 billion over this time period.

Crucially, proposed versions of the surtax apply to capital incomes as well as ordinary income. This is important because the incomes of the richest households are disproportionately made up of capital income. Specifically, capital incomes make up approximately a third of the income of the top 1%, a proportion that has steadily grown in past decades. Therefore, we’ll need higher capital income taxes if we want to target those dollars. This may come in the form of higher rates or broader bases on capital gains, dividends, and corporate income taxes.

Overall, taxes have the power to do much of the heavy lifting when it comes to closing the fiscal gap. By preserving (or even expanding) the ability to maintain our (albeit stingy) welfare state programs, a tax-first approach would not only lead to stronger revenue streams but would also contribute to a fairer economic landscape.

Emily Zhang was an intern at the Economic Policy Institute in the summer of 2023.