U.S. fiscal mess worries international investors

Simple changes in taxation could end problem: economist

Not long ago, the world was fretting about the European debt crisis and the possible breakup of the continent’s monetary union.

Now, the biggest source of anxiety for investors around the world is the continuing failure to address the U.S. fiscal crisis in any meaningful way.

According to a poll of international investors this week by Bloomberg Business News, the U.S. fiscal mess has become the biggest risk to the global economy. Thirty-six per cent of respondents said it was their top concern.

The Jan. 2 deal between the White House and Congress to avoid “the fiscal cliff ” was a temporary solution that didn’t address fundamental tax and spending issues.

The poisonous political atmosphere in Washington has delayed the necessary reforms and put the country on a grim trajectory.

“Absent major policy changes it is a question of when, not if, a major financial crisis will occur,” warned Montreal-based BCA Research this

BCA RESEARCH

week in a report to clients.

With annual federal deficits exceeding $1 trillion and the government debt-to-GDP ratio tracking toward 150 per cent, “the scale of the U.S. fiscal deterioration is too large for it to be sustained.”

For investors, there won’t be any obvious alarm bells. “It is a gradual and insidious process” until a tipping point is reached that requires a drastic policy shift or, in the extreme case, default.

But as BCA chief economist Martin Barnes points out, the U.S. does not lack options here, especially if early action is taken. One obvious front is taxation — the most politically charged area but one with the most scope for change.

The reality is that the U.S. is a low-tax country by global standards and that the current tax burden is low relative to other periods in U.S. history. The tax system is riddled with distortions, so that looking simply at marginal income tax rates gives the wrong picture.

The U.S. is the only advanced country that does not have a national sales tax, which means the government has to rely much more on income taxes than other countries. About 47 per cent of revenue comes from income taxes, compared with an average of 30 per cent among OECD countries. Because many families have low incomes, the burden falls disproportionately on the middle class.

On the flip side, only 18 per cent of tax receipts are derived from consumption taxes, compared with an OECD average of 33 per cent.

Taxing consumption through a national sales

“It is a question of when, not if, a major financial crisis will occur.”

tax would take the pressure off income tax as a revenue source and might encourage more savings and investment. It’s true that such a tax would hit the poor harder but the regressive nature of the levy “could be tackled by exempting food and other essentials and by providing tax credits to the poor,” Barnes says.

A case can also be made for higher excise taxes on gasoline, alcohol and tobacco. “Gasoline taxes average around 40 cents a gallon in the U.S. compared to $4 or $5 a gallon in Western Europe.”

Even tripling the current gas tax rate would leave it low by international standards and help promote conservation and new technologies, Barnes argues.

Eliminating some of the juicy tax deductions in the U.S. system could also go a long way toward restoring fiscal sanity.

One that really jumps out is the mortgage interest deduction, one of the biggest sacred cows in the U.S. tax code. Canada survives fine without mortgage deductibility, although it’s true that, unlike the U.S., we exempt the sale of a principal residence from capital-gains tax.

The problem is that attempts to eliminate deductions and raise specific taxes always run into well-organized opposition by special interests.

The Republicans, as the anti-tax party, also stand in the way. They would rather see action to cut spending on entitlements.

Still, says Barnes, there is plenty of room to change the tax system, improve efficiency and raise revenues.