Forget Washington: Here's how we'd fix the ... - Fortune Finance

FORTUNE -- Partisan politics and tired talking points aren't solving America's economic woes. Mitt Romney says he'll prime the economy with pro-business measures; Barack Obama says he's going to increase stimulus spending while reducing the deficit. But is either talking about the hard choices America needs to make? Fortune's Geoff Colvin and Allan Sloan offer their own commonsense proposal for getting the country back on track.

America's leaders aren't leading -- and the damage is mounting. Citizens have complained for years about Washington's squabbling children, who'd rather stamp their feet and hold their breath than resolve momentous issues of economic policy. The games are childish, but the resulting suffering is serious: Millions can't find work, confidence withers, growth slows, and the self-reinforcing upward spiral that makes an economy grow can't get going -- largely because our supposed leaders won't grow up.

You may have heard such generalities before, but consider this specific: The CEO of a Fortune 50 industrial firm with operations in 180 countries told one of us recently that the prospect of the year-end "fiscal cliff" of tax increases and federal spending cuts means that "we're already holding back on things we'd otherwise be doing. I could show you a list." He doesn't want to be identified, for obvious reasons. But his list represents economic growth that isn't happening because Washington's leaders prefer playing inside-the-Beltway chicken to dealing with a potential economy-crushing problem less than five months away. So the U.S. hobbles on, its GDP growth having slowed from a feeble 2% annual rate in the first quarter to 1.5% in the second.

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Yet U.S. economic policy isn't being meaningfully discussed in the presidential campaign. The addition of Rep. Paul Ryan to the Republican ticket could bring the issue more airtime, but we aren't counting on a substantive discussion breaking out, just candidates endlessly repeating their talking points. Our Fortune colleagues have sought for months to get former governor Mitt Romney and President Barack Obama to share, in detail, their plans for reviving the economy; the fruits of their valiant reporting efforts can be found here and here. Our boss, feeling frustrated by the candidates' lack of specificity, asked us to propose a policy outline that we believe would serve the nation well. In doing so, we emphasize that stability is at least as important as policy. In Washington's immature world of extremes, where "compromise" is a synonym for "treason," crises don't get resolved until the last, looming moment, as with the 2011 debt ceiling embarrassment and possibly with this year's fiscal cliff. Major policy shifts like health care reform pass without bipartisan support. When Standard & Poor's announced its historic downgrade of America's credit a year ago, it explained that the move "reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened." Managers, investors, and consumers have no idea what's next, what will last, and what will be reversed after the next election or perhaps after the next news cycle. Result: a CEO's on-hold list, multiplied across the country.

America needs more than just smart moves to get a struggling economy moving. We have to increase tax revenue and reduce spending growth. Most important, we have to give neither side everything it wants -- to adopt policy so relentlessly bipartisan that it attracts strong, stable support from both sides. Believe it or not, that has been the norm in U.S. history, even though fundamental disagreement between the parties is eternal. Former senators George Mitchell and Bob Dole, grownups who led the Senate's Democrats and Republicans, respectively, in the 1990s, had dinner together every week and successfully did business; they also held each other in the highest personal regard and still do. Today, however, researchers at Princeton and the University of Georgia find that Republicans and Democrats in Congress are further apart than at any time in the 120-year period they studied.

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Many people in other countries still envy the U.S. Our system is more open and transparent than most, our economy stronger and more resilient. But we can't settle for a government performing as badly as ours now is. Artificially created crises like the debt ceiling get only expedient kick-the-can-down-the-road responses, and major problems like Medicare aren't even addressed. All-or-nothing intransigence is paralyzing the system.

That's why this article carries a joint byline. Your two authors have been writing about these issues for decades. We're both data-driven, yet tend to arrive at different conclusions. Beyond that, in journalistic and personal styles we are wildly different (just trust us on that). If the two of us can agree on policy prescriptions, then maybe Washington can too. Believe us, neither one of us got everything he wanted. But we've ended up with a package we can both live with and we think would help the country climb out of its economic rut.

"Current policy is unsustainable," says the Treasury's latest Financial Report of the United States Government, and we agree. Absent substantive changes, federal debt will soon rocket to levels no country can bear. The only solution is fundamentally changing spending and taxes in ways that eventually balance revenue inflow and outgo.

Spending

By far the largest elements of unsustainable spending are America's biggest social insurance programs, Medicare and Social Security. People talk about them as linked entitlements, but they're really quite different. Social Security is emotional but is primarily about numbers, and you can compromise numbers in many, many ways. But Medicare is emotional times 10 -- it's about who lives, who dies, and who pays for it.

Hence even the Simpson-Bowles commission on fiscal reform, which made daring, detailed proposals for spending cuts, suggested almost no specifics for Medicare. Former Fed chairman Alan Greenspan, who chaired a Social Security reform commission in the early 1980s, says Social Security is an easily fixable problem: "If you get the right people in the room, you can solve Social Security in 15 minutes, and the first seven minutes are pleasantries." Medicare, he says, is a far tougher challenge.

The biggest problem in dealing with Medicare is the endgame -- when people enter their final descent and are kept alive, expensively, often with no statistically significant chance of leading what most people would consider a decent or rewarding life.

So we would restrict the end-of-life care that Medicare will pay for. Yes, that sounds like the nonexistent "death panels" invoked during the debate over the Affordable Care Act, a.k.a. Obamacare. But insurance companies, hugely important players in our health care system, already heavily restrict the procedures they pay for. Taxpayers, collectively, should do the same.

In 2006, the last year for which data are available, more than 25% of all Medicare spending went for people in their last year of life, according to the federal Centers for Medicare and Medicaid Services, even though they were only 5% of the covered population. When baby boomers, who are beginning to enter Medicare and as a group are still relatively healthy, reach their terminal years, the end-of-life expense will blow through the roof unless we deal with it now.

Both of us have been through deaths of close family members, and we know the pain, suffering, and emotional trauma involved in letting loved ones pass on. But sometimes you just have to do that.

We propose that if you want to use heroic measures to keep yourself or any other Medicare or Medicaid recipient alive -- we'll leave it to experts to define "heroic measures" -- either spend your own money or buy a supplemental end-of-life policy from the market that will doubtless spring up if our proposal is adopted.

We'd also surcharge smokers and the ultra-fat for their Medicare coverage. Since the U.S. Surgeon General's report in 1964 linking cigarettes to lung cancer, people have known definitively that smoking is bad for your health. Continuing to smoke once you've started is often an addiction -- but starting to smoke is a choice. Ditto for people who are grossly overweight, except for a handful of cases in which morbid obesity is caused by a medical condition.

Social Security is a smaller problem but still a problem. We'd explicitly make Social Security a pay-as-you-go system and adjust it to work on that basis, wiping out the deceptive Social Security trust fund.

The fixes are simple and obvious: Bring in more money by slightly adjusting the payroll tax, and change the benefit formula to reduce benefit growth over time to the highest-income beneficiaries. Social Security tax is levied only on salary income up to $110,100 (while Medicare tax is levied on all salary income), and that wage base rises gradually over time. Let's raise it a little faster while also edging up the retirement age to keep pace with increasing life expectancies. That would do it.

The $3 trillion Social Security trust fund, while impressive on paper, is of no economic value because the government has to sell new Treasury securities to raise the cash to buy the Treasury securities that the Social Security trust fund liquidates in order to meet its obligations. The bookkeeping is so complex and misleading that it causes some people to say the system is broke, which it isn't, and others to say it's flush, which it also isn't.

In making Social Security explicitly pay-as-you-go and eliminating the trust fund, we'd allow a specified subsidy from general tax revenues to compensate current and future beneficiaries for the excess Social Security taxes they've paid since 1983, when Congress raised Social Security taxes and cut benefits. This isn't an ideal solution, but it's certainly preferable to today's baffling whirl of Washington legerdemain. That subsidy would be phased out over 25 years or so, and we'll then have a system that people can understand and have confidence in.

The largest element of spending after social insurance is defense. Its budget can and should be cut. Even a staunchly pro-military Republican like former Sen. Alan Simpson likes to point out that America's defense budget, by far the world's largest, is greater than the combined defense spending of the next 15 biggest defense spenders. For those in Washington freaked out by the possible mandatory defense cuts if the fiscal cliff actually happens, here's a great opportunity to act like adults. In May the House of Representatives voted to give the Defense Department some $3 billion more than it requested for 2013 (which was $519 billion). It's time for members to think less about directing pork to their districts and more about the nation's future.

Taxes

The Harvard Business School, as part of its U.S. Competitiveness Project, recently conducted a first-ever survey of its alumni worldwide. Nearly 10,000 responded, and they were blisteringly clear about the worst part of doing business in America vs. other countries: "Complexity of tax code" was their top choice. And when they were asked how 17 competitiveness factors were changing in the U.S., the tax code ranked dead last on getting better.

Our tax code is dragging the nation down. Here's how to stop the damage.

Our mantra is "Broaden the base and lower the rates." Broadening the base means getting rid of the endless special breaks -- the targeted deductions, credits, exclusions, and other features -- that have accumulated on the tax code like barnacles on a boat. They're a main reason the tax code is so staggeringly complex, longer than War and Peace, and impossible for anyone to comprehend fully.

But they do much more damage than just adding complexity. They cost a ton. These breaks, which policy wonks call tax expenditures, totaled about $1.2 trillion last year, according to federal budget documents. That's more than the revenue brought in by all individual income taxes.

Further, by making various favored activities less expensive for individuals or companies, special breaks distort economic incentives, drawing money away from other activities. And because special breaks let some people and companies pay less tax, rates have to be raised on everybody else. Broadening the tax base by wiping out special breaks -- including the very favorable treatment investment income gets -- exposes more taxpayers to the same tax rates, which can thus be lowered substantially while still bringing in the same revenue -- in a simpler, fairer way.

Here's what we'd get rid of. Be warned that every change gores somebody's ox, which is why, as we've said, the ancient art of political horse-trading has to be rediscovered in Washington.

The exclusion for employer-sponsored health insurance

The fact that employees pay no income tax on the value of health insurance they get from their employer is the biggest, weirdest break of them all, originally created by employers who found a loophole in World War II?era wage and price controls and used "free" health benefits as recruitment tools. This bizarre break cost the federal government $177 billion last year and makes no economic sense. It makes health insurance more expensive for people who have to buy it on their own. Because it's a tax break, it's more valuable to high earners than to low earners -- an odd way to subsidize health care. And because it's a tax-free element of pay, employees tend to want (and employers tend to offer) more compensation in the form of health insurance than they otherwise would, encouraging overspending on health care.

The Affordable Care Act includes provisions meant to counter some of those effects. But why tinker? Let's expose health care to more economic reality while leveling the field for people who buy health insurance.

The tax deduction for mortgage interest

This is the No. 2 tax expenditure, about $105 billion last year, but it may be the No. 1 sacred cow in tax policy. A vast housing industry of builders, brokers, furnishers, and others deploys a fearsome army of lobbyists to protect this break. In addition to being expensive, it makes no sense. We wouldn't create it today if it didn't already exist. It disproportionately favors high earners, and it encourages overbuying and overbuilding of homes. Eliminating this deduction at a stroke would be unfair to those who bought under existing rules, so we'd have to phase it out; but with home values still deeply depressed, now would be a great time to start. If you're one of the many who believe life as we know it can't continue without this deduction, remember that Canadians get along just fine without it -- and they didn't have a housing bubble or bust.

The tax deductions for state and local taxes and for charitable gifts

Together these breaks cost the Treasury about $90 billion last year (not counting the deduction for local property taxes). While these are popular deductions, no economic logic supports them; they amount to federal subsidies for state and local taxation and for philanthropy, though there's no reason to support those activities at the expense of countless others.

We wouldn't ax all special breaks. We'd keep the Earned Income Tax Credit, which is an important source of support for low-income workers with kids. Liberals like the EITC because it's a surviving bit of federal welfare; conservatives like it because it was championed by Ronald Reagan.

Those changes let us improve the individual income tax in a couple of important ways. One, we can drop the AMT. The alternative minimum tax is the outgrowth of a clumsy 1967 attempt to keep a handful of ultra-high-income people from totally avoiding federal income tax. But it has morphed into a monstrosity that whacks mainly middle-class and upper-middle-class taxpayers. Besides, we're eliminating many of the mechanisms for tax avoidance. Two, we can significantly lower tax rates across the board. The Simpson-Bowles commission made a rough calculation that a structure similar to what we've outlined would bring in the same tax revenue we currently get but with just three tax brackets -- 9%, 15%, and 24%, all much lower than today's rates. It's a simpler, broader, fairer system.

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The same principle -- broaden the base, lower the rates -- applies to corporate taxes. Tax expenditures for corporations aren't nearly as expensive as those for individuals, and in the realm of corporate tax breaks, those targeted at specific industries -- oil and gas, insurance, renewable energy -- are only a minor percentage. Such corporate welfare is small potatoes economically, but we'd still eliminate it for the same reasons we'd drop special breaks for individuals: They increase taxes for others and distort incentives. They also carry significant symbolic value.

But the biggest corporate tax expenditure by far is the deferral of tax on income earned by multinationals abroad. Your authors confess they don't yet see eye to eye on the best solution. One of us favors a territorial system in which U.S. companies pay the tax levied on income in each of the countries where it's earned; the other favors a global system in which U.S. companies pay U.S. taxes on all their income but get credits for cash taxes they've paid abroad. We'll keep working on it. In the meantime, what we agree on would simplify the system and allow the current rate (35%) to be cut without loss of revenue.

We're proposing major tax and budget reform. Some people would argue it can't possibly happen. But our differences notwithstanding, both your authors are congenital optimists. Major reforms happened under Presidents Kennedy and Reagan, and if our country gets a big enough scare, they could happen again. These things have their moments. As the economy cries out for help -- for adult supervision at last -- just maybe the moment has arrived.

This story is from the September 3, 2012 issue of?Fortune.

Source: http://finance.fortune.cnn.com/2012/08/16/washington-economy-fix/

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