The Solution

The Solution
by Charles Krauthammer
08/05/2011

WASHINGTON -- Conventional wisdom holds that the congressional super-committee established by the debt-ceiling deal to propose further deficit reduction will go nowhere. I'm not so sure. There is a grand compromise to be had. It does, however, require precise sequencing. To succeed it must proceed in three stages:

(1)Tax Reform.

True tax reform that removes loopholes while lowering tax rates is the Holy Grail of social policy. It appeals equally to left and right because, almost uniquely, it promotes both economic efficiency and fairness. Economic efficiency -- because it removes tax dodges that distort capital flows (and thereby diminish productivity) while cutting marginal tax rates (thereby spurring growth). Fairness -- because a corrupted tax code with myriad breaks grants deeply unfair advantage to the rich who buy the lobbyists who create the loopholes and buy the lawyers who exploit them.

Which is why the 1986 Reagan-Bradley tax reform was such a historic success. It satisfied left and right, promoted efficiency and fairness, and helped launch two decades of almost uninterrupted economic expansion.

But didn't that agreement take years to hammer out? Yes. Today, however, the elements are already laid out by the Simpson-Bowles commission. The super- committee doesn't have to reinvent the wheel. It simply has to make choices.

(2)Revenue Neutrality.

Every dollar of revenue raised by stripping out a loophole is to be returned to the citizenry in the form of lower tax rates. Initial revenue neutrality avoids ideological gridlock over tax hikes and ensures perfect transparency during any later alterations of that formula.

Start with the obvious boondoggles, from the $6 billion a year wasted on ethanol subsidies to your Democratic perennials -- corporate jets, oil company breaks, etc. That's the fun part. Unfortunately, whacking that pinata yields but pennies on the dollar. The real money is in the popular tax breaks: employer-provided health insurance, mortgage interest, and charitable contributions. Altering some of these heretofore politically untouchable tax breaks would alone be a singular achievement.

I'd suggest abolishing the health care exclusion, which encourages wasteful medical spending. I would also gradually abolish the mortgage-interest deduction. Start by excluding second homes and mortgages greater than, say, $500,000. Lower that threshold by $100,000 chunks as the housing market meets certain threshold indexes of recovery.

As for charitable contributions, here I go soft. I'd leave the deduction intact on the Madisonian grounds that subsidizing private charity -- donations to institutions chosen by the citizens, not the state -- disperses power and strengthens civil society, the principal bulwark against state domination.

Your preferences will be different. So will the super-committee's. It doesn't matter. What's important is to make choices that are deep, radical and revenue-neutral.

But, you say, is not the committee's mission to reduce debt? This, as yet, does nothing. Correct. But it's the indispensable premise for achieving the ultimate in debt reduction:

(3)The Grand Bargain.

Once you have serious revenue-neutral tax reform in place, the ideological horse-trading that is required for massive deficit reduction -- tax hikes versus entitlement reform -- can begin.

Republicans will resist the former, Democrats the latter. But tax-reform-first makes possible the compromise that eluded John Boehner​ and Barack Obama​. Boehner was willing to increase revenues by $800 billion. Obama was reputedly ready to raise the Medicare age and change the Social Security cost-of-living formula.

Remember: Tax reform will already have slashed rates radically. In one Simpson-Bowles scenario, the top rate plunges to 23 percent. Conservatives could at that point contemplate increasing net revenues by slightly tweaking these new low rates, say, back to Reagan's 28 percent, still much lower than the current 35 percent and Obama's devoutly desired 39.6 percent. The deviation from revenue neutrality would yield new tax receipts for the Treasury, in addition to those resulting from the economic growth stimulated by the lower rates.

Democrats would have to respond by crossing their own red line on entitlements. That means real structural changes. That means raising the Medicare and Social Security ages, indexing them to longevity (until 70 becomes the new 65) and changing the inflation formula. Perhaps even means-testing Social Security (after one has recouped what one originally paid in).

The result of such a grand bargain would be debt reduction on a scale never before seen. World confidence in the American economy would rise dramatically. Best of all, we would be back on the road to national solvency.

It can be done. In three months. In three stages.
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