April 3, 2012 / 11:01 PM / 6 years ago

U.S. should end Bush tax cuts to shrink debt: economist

NEW YORK (Reuters) - Americans may need to take a wage cut if they want to start dealing with the deepening U.S. debt crisis, a former chief economist of the International Monetary Fund says.

For Simon Johnson, the Bush-era income tax cuts represent a de-facto pay hike that Americans happily accepted in 2001, but at the expense of the country’s fiscal discipline.

“ We gave ourselves a big pay rise with the Bush tax cuts and frankly it is not sustainable,” said Johnson, whose new book on the U.S. deficit and debt challenges was published on Tuesday.

“White House Burning” is named after an episode during the war of 1812, when the British attacked the White House and Capitol Hill. The raid underscored the lack of tax revenues the fledging United States needed to defend itself against its enemies, and a lesson in the importance of careful budget management that America heeded for centuries afterwards.

In the book, Johnson and co-author James Kwak tell the story of how that discipline began to fall apart in the 1980s with the low-tax focus of the Reagan administration.

The U.S. public net debt load now stands at an estimated 78 percent of gross domestic product and is set to rise.

Johnson and Kwak pin the debt on both U.S. political parties for failing to understand the importance of keeping the surplus the government had as recently as 2001.

In the near term, getting a grip on U.S. finances depends in large measure on what Washington decides to do with the Bush-era income tax cuts when they expire on December 31, the authors argue.

“There is an interesting and important moment at the end of this year when the Bush cuts expire and there is a real possibility that the president can veto (the extension of) those tax cuts,” Johnson said in the interview.

The sums involved are enormous. A permanent extension of the personal income and estate tax cuts would increase the U.S. public deficit, currently estimated by the IMF at nearly 8 percent of GDP, by nearly another 3 percent of gross domestic product by 2021, the book says.

If the Bush cuts expire and Obama is re-elected, he could propose his own tax cuts, such as a payroll tax cut that could be phased out depending on the health of the labor market, Johnson said. “It would be very hard for the Republicans to resist voting for it,” he said.

In the likely event that Washington cannot resist the temptation to make the Bush tax cuts permanent, Congress should act sooner rather than later to show its intent to start narrowing the deficit by agreeing to some limited though probably painful measures.

The book’s suggested fixes include increasing the payroll tax for social security by one percentage point, reducing the tax exemption on health care insurance for employees, taxing excessive risk-taking by financial institutions and reducing the mortgage interest deduction, among others. A minimum level of tax increases would help balance the budget without losing social plans, like Medicare, Medicaid and pensions, it says.

Those measures would be enough to narrow the deficit and push the debt back toward a more comfortable level of 50 percent of GDP by 2030, Johnson and Kwak estimate.

“This book is not endorsing big government,” says Johnson. His studies at the IMF showed the amount of U.S. tax revenue as a percentage of GDP has been at its lowest since the World War Two.

At the same time, he says any government needs to provide citizens with much-needed social programs such as health insurance for the elderly.

Therefore, Johnson and Kwak argue, now is the time to act before an aging U.S. population makes things even harder.

The threat posed by the U.S. debt is far from immediate, they write. With foreign and domestic investors hungry for Treasury bonds, denominated in what remains the world’s major reserve currency, the United States can cope with the existing deficit and debt levels, plus a new major financial crisis or even a war almost without losing stride.

“But we should not assume that we will have that capacity forever,” Johnson said, noting how things can easily turn ugly, as the European debt crisis has shown.

In the long term, either voters will accept sacrifices to ensure that the U.S. debt is brought down to a sustainable level, or bond investors will do it, though probably in a more brutal way, just as they are doing to Greece and Ireland.

“One way is much better that the other,” the book says.

Johnson says it is time to restore the fiscal discipline that the Founding Fathers learned the hard way. He believes Americans will make the right call.

“As Winston Churchill said: ‘Americans always do the right thing after first exhausting all the other possibilities.’”

Reporting By Tiziana Barghini; Editing by Dan Grebler

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