Originally Published in the BOSTON GLOBE

Tuesday, February 3, 1998

Budget surplus in sight, time is ripe for smart tax policy


Martin and Kathleen Feldstein

"Congress should recognize that a budget surplus is not a reason for new spending."

For the first time in decades, there is a prospect that the federal budget will actually be in surplus during the next decade. And, predictably, politicians are squabbling about how to respond to this unexpected windfall.

The Congressional Budget Office has said that if current policies remain unchanged and if no external surprises send the economy into recession, the budget will essentially be in balance for the next three years and will then show surpluses for the 10 years after that.

The CBO warns that its forecast depends on assumptions that could prove overly optimistic and that it assumes that Congress and the president will adhere to caps on discretionary spending that have been written into law but that Congress and the president could change. The CBO also cautions that legislative action must be taken soon, to prevent the retirement costs of the baby boom generation and the continued growth in health care costs for the elderly from sending the federal budget back into large deficits after 2010.

Fortunately, poll results show broad popular support for using budget surpluses to reduce the national debt. Since the debt has increased by more than three trillion dollars over the past 20 years, using the projected $600 billion of surpluses over the next decade to reverse some of that increase would certainly be a good idea. And it would be really good news for the long-term health of the economy.

Reducing the national debt over the next decade would mean that the government will buy back some of the outstanding government bonds. Those who sell the bonds to the government will then channel the money that they receive into private stocks and bonds. The result of this process will be lower interest rates and increased investment in productivity-enhancing business plant and equipment. In addition, the reduction in the outstanding stock of government bonds will mean lower tax burdens (and reduced tax distortions) on future generations because less money will be needed by the government to pay interest on the debt.

But well be surprised if, through the political process, at least some of the projected surplus is not used to finance politically popular spending programs and tax cuts. Congress should recognize that a budget surplus is not a reason for new spending. Whether there is a projected surplus, new spending means taxes must be higher or the national debt must be larger.

We hope the tax cutters will choose cuts that improve economic incentives in addition to reducing tax bills. Bill Archer, chairman of the House Ways and Means Committee, has proposed splitting the surplus equally between reducing the national debt and cutting taxes. Among the alternative tax cut proposals that he is said to be considering -- and that we like -- is one that would reduce the marriage penalty that the current income tax rules impose on many couples.

Eliminating the marriage penalty has the support of both parties, and it is the right kind of change because it can reduce an existing tax distortion. Through the perversity of the current tax schedule, a married working couple filing jointly can pay more in taxes than two individual taxpayers with the same total income. For example, two single individuals each making $40,000 would each pay federal income tax of $6,092, a total of $12,184. If they marry, their tax burden rises to $13,628. (Not all couples are adversely affected this way. Because there are separate schedules for married and single taxpayers, couples with only one wages earner, or two-earner couples where there is a very large disparity in incomes, pay less in taxes than would two single individuals with the same combined income.)

The current rules not only impose an inequitable tax on many couples but also discourage spouses from taking jobs or seeking higher-paying jobs because of the high marginal tax rate on second-earner wages. One way to reduce the inequity while strengthening incentives would be to establish a separate schedule for taxing the wages of second earners. A second way would be to return to excluding a portion of a second earners wages from taxable income. Both could remove the marriage penalty and increase the share of additional earnings spouses get to keep.

Another tax cut proposal that we like (because of its favorable impact on saving) would allow individuals to place a portion of their pretax earnings (say, up to $1,000) in a special IRA that could not be drawn on until age 65. They would receive a dollar-for-dollar tax credit for the funds that are deposited in these special IRAs. In effect, savers would receive a tax cut on the condition that it would all be saved for their retirement years.

If responsible policy makers want to heed the CBOs advice to prepare now for the increasing burdens of retirement and health security, here are places where they should begin.

Martin Feldstein, the former Chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.