News Analysis date published New: 
Tuesday, September 6, 2011 - 11:00
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Thursday, September 8, 2011 - 11:03
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Tuesday, September 6, 2011 - 11:00

The Key to Solving the U.S. Debt Crisis

Tuesday, September 6, 2011 - 11:00am

Washington has a mess on its hands.

To close the budget gap and start paying down the nearly $15 trillion in debt we've already incurred, legislators will have to make some very tough choices regarding which programs to cut.

Defense, education, transportation, social security, homeland security -- none of these will be spared the budget cutter's repeated axe.

How many cuts take place will depend on changes in tax policy -- a subject that seems to rub everyone the wrong way, regardless of how they feel on the issue. The overwhelming consensus (or at least the loudest) is that corporations and individuals alike are already overtaxed.

The trouble is, history argues otherwise. If anything, taxes are at a multidecade low thanks to major tax breaks granted by both the Bush and Obama administrations.

Don't believe me? Let's look at the numbers.

Corporations
Back in the early 1950s, corporate America paid enough in taxes to account for roughly 5% of the size of the U.S. economy. Not anymore. This figure now stands at 1%.

Any corporation with more than $100,000 in profit is supposed to pay a roughly 35% tax rate. But few companies actually pay that. Instead, the last few decades have seen an explosion of corporate tax loopholes for research and development (R&D), energy exploration and many other goodies.

In fact, Microsoft (Nasdaq: MSFT), Coca-Cola (NYSE: KO), Citigroup (NYSE: C) and Verizon (NYSE: VZ) all paid a tax rate below 20% in 2010 thanks to all the loopholes in place. And they were comparatively lucky. GE (NYSE: GE), Ford (NYSE: F), Morgan Stanley (NYSE: MS) and Pfizer (NYSE: PFE) paid less than 12% of their income to the tax man.

By collecting fewer taxes from corporations, other taxpayers must take up the slack. In 1934, individuals paid $420 million in taxes and corporations paid $364 million -- a roughly 54%/46% mix.

By 1950, individuals were paying 58%. In 1960, it had grown to 68%. In 1990, it was 77%. Today, individuals pay 83%, meaning that less than a fifth of federal taxes come from corporations. It looks like decades of corporate lobbying have really paid off.

Still, many legislators insist that companies are overtaxed, so they repeatedly push for the 35% tax rate to drop to 25%. This can be accomplished, but only if many cherished loopholes such as the R&D tax credit, the ability to write off the expense of corporate jets, the capital-gains tax rate (of 15%) on investment money managers, etc. are abolished.

Individuals
What about individuals? Are they overtaxed relative to history?

No way. For starters, roughly half the U.S. population pays no formal federal income tax thanks to the earned Iicome tax credit (though they are heavily taxed in terms of gas taxes, user's fees, state and local taxes, etc. so characterizing them as freeloaders is a bit unfair).

And thanks to tax cuts established under George W. Bush and maintained by President Obama, tax rates for the upper and middle classes have been reduced since the 1990s. The top 1% in particular has seen a notably sharp drop in effective tax rates, thanks to a virtual explosion of tax shelters cooked up by accountants. According to a study conducted by the Detroit Free Press, the top 5% of earners in 2009 paid an effective rate of 20%.

So if the top earners and bottom earners are doing okay, what about the middle class? That seems to be the heart of the emotional debate about taxes. Many will tell you it's getting harder by the year to make ends meet, and they instinctively assume that rising taxes are part of the problem.

According to the Brookings Institution, a family of four in the exact middle of the income spectrum paid only 4.7% of its income in federal income taxes in 2010, the third-lowest percentage in the past 50 years, after 2008 and 2009.

Here again, those in the median income range have gotten tax breaks, even when they don't notice it. When the Obama administration took office, it enacted a payroll tax holiday to boost the size of people's paychecks. But pollsters found that the majority of Americans had simply not noticed their paychecks had suddenly grown larger.

The real squeeze on the middle class: income. Wages have been stagnating for nearly two decades, even as the cost of many items keeps rising. This is the flip side of a world where corporations are boosting record profit margins by keeping a tight lid on raises.

The government
OK, so if corporations and most individuals are paying less than they used to (as a percentage of income), what does it mean for the government's income?

A February 2011 article in USA Today noted "federal tax receipts will equal 14.8% of the gross domestic product (GDP), the lowest level since Harry Truman was president." Meanwhile, government spending, which averaged 20.8% of GDP from 1971 through 2010, is at its highest level since World War II, as the following chart shows.

Social programs such as unemployment benefits, along with rising defense spending and an increasing number of people on Medicaid and social security get much of the blame.

The solution
Not only do lawmakers need to close the taxation (14.8%) and spending gap (25.36%), but they also need to start paying back past borrowings.

Looking at all these factors, it's clear that everyone will need to pull their weight to help pull us out of this morass:

  • As Warren Buffett suggests, the very rich need to stop standing by loopholes and pay their share (he specifically calls for a 35% tax rate on those earning $1 million or more and boosting the capital gains rate to the ordinary income tax rate).
  • Companies need to be sure that they are paying salaries that can truly sustain a middle class family in these toughening times.
  • Companies also need to start parting with vigorous tax breaks. (Do we really need to give ExxonMobil (NYSE: XOM) tax incentives to look for oil?)
  • Individual taxpayers need to start accepting the reality of tougher health care and retirement cost structure.
  • Defense hawks have to settle for a pullback in our vast military complex.

Of course, it all starts at the top. Washington needs to show leadership to help us see the tough choices we face.

So as we turn the corner to the upcoming election year, these are the questions you should be asking yourself and potential candidates:

If any tax hikes are out of the question, then what sacrifice will you make? A smaller military? Larger classroom sizes? Fewer police officers and fire fighters? Reduced medical benefits for the elderly, indigent and veterans? Bridges that operate long before the intended useful life?

Each of us is willing to identify specific sacrifices that others find unnecessary. For example, I have no children so I am not a fan of my ever-rising school taxes. (Then again, I want to live in a society where the next generation is as well-educated as my generation.) I live in a low-crime area and question why my town needs such a large police force. Then again, what would crime levels in my town be like if there were fewer police officers? I drive a lot, so strong bridges are important to me. If you live in a city, that's not as much a priority.

Action to Take --> The real takeaway is that there is no free lunch. We simply can't afford to make our individual choices when it comes to taxes and spending. We must find a middle ground that (mostly) satisfies all of us.

One thing's for sure. Without a real solution -- and fast -- our fiscal mess gets only deeper.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.