DANGER!: Tax Challenges for the Next President

The ghost of David Stockman still haunts us. It was Mr. Stockman, Ronald Reagan's budget chief, who proclaimed 27 years ago: "I'm just not going to spend a lot of political capital solving some other guy's problem in 2010." That other guy -- or gal -- will be the next president of the United States. To be sure, in many ways the federal budget is in better shape today than it was in Mr. Stockman's day. As a share of the economy, federal outlays and receipts were smaller last year than in fiscal year 1982. Because outlays fell more than receipts, the federal budget deficit amounted to only 1.2% of GDP last year, down from 4% in 1982. In fact, if the economy grows as projected and Congress maintains current tax laws and spending policies, the Congressional Budget Office (CBO) projects a federal budget surplus by 2012.

That's the good news. Nevertheless, our next president will encounter three ticking tax bombs in the weeks following the inauguration, as he or she prepares the budget for fiscal year 2010. Should even one of them detonate, we all will suffer the consequences.

The first ticking bomb is the fate of the Bush tax cuts. CBO's optimistic federal budget surplus projection is based on the assumption that Congress will allow the president's tax cuts to expire as scheduled at the end of 2010. That would trigger the largest tax increase in history (nearly $1.9 trillion over seven years), raising taxes on 115 million taxpayers, and returning to the tax rolls 7.8 million low- and middle-income families who now pay no federal income tax because of the Bush tax cuts.

If this bomb explodes, one thing is certain: It will damage the economy. The Institute for Research on the Economics of Taxation estimates the tax hike would, in the short run, oblige the economy to "flirt with recession" or worse.

The enduring effect would be to reduce the growth path of the economy, permanently reducing potential GDP by 5% to 6% compared to the levels projected under current tax rates. That would wipe out most of the supposed revenue from the expiration of the tax cuts and turn the projected surplus back into deficit.

The second tax bomb is the Alternative Minimum Tax, or AMT, which the budget surplus projection assumes will detonate. This bomb has a long fuse, stretching back to January 1969. That's when the Secretary of the Treasury testified before Congress that 155 taxpayers earning $200,000 or more used legal loopholes to avoid owing any income tax in 1966. The public reaction was instant and intense. According to Yale Law School professor and former Treasury official Michael Graetz, Congress received more angry letters in 1969 about these 155 taxpayers than they did about the Vietnam War.

Bowing to public outrage, Congress quickly established an add-on minimum tax to, in the words of the New York Times of 1969, "foil wealthy people who arrange their affairs to escape taxation under the present law." Several iterations later, it has evolved into the modern individual AMT.

Because the AMT was not indexed for inflation, increasing numbers of middle-income taxpayers have become subject to this so-called "tax on the wealthy." Mindful of the political consequences of doing nothing, Congress routinely adopts temporary patches to forestall an explosion in the number of taxpayers subject to the AMT.

The numbers are staggering. If Congress had not extended the latest patch in December, the number of taxpayers affected by the AMT would have risen to 25 million in 2007 from four million in 2006. "If no further changes are made to the AMT," reports the Treasury, "the number of taxpayers affected by the AMT is expected to grow to over 56 million by 2017."

Defusing these two bombs -- that is, extending the Bush tax cuts (and other expiring tax provisions) and indexing the AMT for inflation -- would reduce federal tax receipts slightly more than $3.2 trillion from fiscal years 2010 through 2017, on a static revenue estimation basis. In reality, much of that $3.2 trillion would never materialize, due to a weaker economy.

Given that CBO's budget baseline projects the federal government will spend $29.6 trillion over those eight years, Congress could defuse these bombs without creating a dime of deficit. It would merely have to scrape by and spend "only" $26.4 trillion -- which it may have to do anyway if the revenue proves elusive. To put these numbers into perspective, consider that the federal government spent $18 trillion over the past eight years.

The third tax time bomb is America's looming entitlement crisis. As increasing numbers of baby boomers retire, Medicare will slide toward insolvency and federal spending on Medicaid and other health-care programs will skyrocket.

CBO estimates that spending on Medicare and Medicaid will grow to 5.9% of GDP by 2017, up from 4.6% in 2007. Social Security, will increase to 4.8% of GDP, up from 4.2%. CBO adds: "Beyond 2017, those trends are poised to accelerate." Unless Congress is willing to slow the growth of entitlements, future taxpayers will be saddled with unsustainable budget deficits or massive tax increases.

Medicare promises to be an especially contentious problem for the next president. According to the latest Medicare Trustees' report, "Beginning in 2011, [Medicare] costs are projected to exceed income including interest, and assets must be redeemed each year until the trust fund is exhausted in 2019."

While it would be possible (and utterly irresponsible) for the next president to avoid addressing the larger issue of entitlements, he or she will find it next to impossible to put off doing something about Medicare before the end of a second term. To do nothing would allow Medicare to become insolvent, but not before draining hundreds of billions of dollars from general revenue.

The next president may call upon Congress to raise payroll taxes to "save" Medicare. Consider the last 30 years. Confronted with Social Security and Medicare funding shortfalls, Congress hiked payroll tax rates in 1978, 1979, 1981, 1982, 1984, 1985, 1986, 1988 and 1990. These hikes erased the near-term operating shortfall with money to spare.

Trillions of surplus payroll-tax dollars flooded the Treasury's coffers, and by law they had to be "invested" in Treasury bonds and placed in the Social Security and Medicare trust funds. The worst kept secret in Washington, D.C. is that the trust funds got IOUs and Congress got to spend the money -- nearly $1.7 trillion from fiscal years 1985 through 2007.

With less than a year to go before the next presidential election, there is more at issue than is regularly being debated by the presidential candidates. The next president -- David Stockman's "other guy" -- will inherit a federal budget on the verge of an apparent surplus, but with three ticking tax time bombs that threaten economic carnage and a budget meltdown. Tick. Tick. Tick.