The Congressional Budget Office (CBO)The Congressional Budget Office (CBO) provides nonpartisan analysis to the U.S. Congress on federal economic and budgetary matters. has given us a sobering look into our fiscal future under the Build Back Better Act (BBBA), estimating that if all the bill’s policies were made permanent, $3 trillion would be added to the national debt over the next 10 years. This is on top of more than $7 trillion in deficits over the last two years, leading to a $21 trillion total national debt held by the public this year (about the size of GDP). Under current law, the CBO predicts national debt held by the public will reach $36 trillion in 2031, or 106 percent of GDP—the highest debt load in U.S. history.
President Biden and congressional Democrats have committed to fully offsetting the budgetary cost of extending BBBA but have thus far not specified how. In practice, the only demonstrated way to raise that kind of revenue is through broad-based taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. increases on the middle class, typically through higher income and payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. es or by introducing a new tax on consumption such as a value-added tax (VAT)A Value-Added Tax (VAT) is a consumption tax assessed on the value added in each production stage of a good or service. Every business along the value chain receives a tax credit for the VAT already paid. The end consumer does not, making it a tax on final consumption. , similar to what is done in European countries, where the tax-to-GDP ratio is much higher than U.S. levels.
For instance, Denmark currently has the highest top tax rate on personal income in Europe at 55.9 percent. The BBBA would exceed that by raising the U.S. top tax rate to 57.4 percent, including the scheduled return of the top federal rate to 39.6 percent, the proposed wider application of the 3.8 percent net investment income tax (NIIT) to income above $400,000, the 8 percent surcharge on modified adjusted gross income (MAGI) above $25 million, and state taxes. The difference is that Denmark’s top tax rate applies to all income above 1.3 times the average income, which in the U.S. would be equivalent to taxing all income above $70,000 at the top tax rate.
Needless to say, no one in the U.S. is proposing a Denmark-style, broad-based increase in the income tax, but that is one of the few remaining options to generate sufficient revenues to pay for the BBBA and grapple with our looming debt under current law. For instance, according to our modeling, applying an additional 5 percent tax rate to all taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. would generate $6.5 trillion in revenue over 10 years. It would also shrink the economy by over 2 percent in the long run and eliminate more than 2 million jobs. Alternatively, increasing income tax rates across the board by 10 percent would increase revenue by $2.1 trillion over 10 years, while shrinking the economy by almost 1 percent and eliminating almost 1 million jobs.
Because the U.S. income tax is so progressive, in fact more progressive than income taxes in Europe, completely flattening the U.S. income tax would actually raise large amounts of revenue while boosting the economy. For instance, replacing the current progressive income tax with a flat income tax rate of 20 percent applicable to all taxable income would generate $1.1 trillion in tax revenue over 10 years, increase GDP by 1.3 percent, and add 1.2 million jobs. It would, however, be a large tax increase on the middle class, reducing after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income. s of the middle quintile of earners by about 5 percent initially and 3 percent in the long run.
It is also possible to raise large amounts of revenue while cleaning up the income tax code by eliminating various deductions and exemptions, generally tax preferences used by middle- and high-income earners. For instance, eliminating the deduction for state and local taxes (SALT) would raise $1.6 trillion over 10 years, and eliminating the home mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction. would raise nearly $1.1 trillion. Each reform would shave almost 1 percent off the after-tax incomes of the middle class in the long run.
Another revenue-raising option is increasing payroll taxes. In Germany, France, Italy, and several other European countries, the social security payroll tax on the average worker exceeds 30 percent—more than double what it is in the U.S. If the U.S. were to increase the Social Security payroll tax by 3 percentage points, it would raise $2.0 trillion over 10 years, while reducing GDP by 0.5 percent and eliminating about 500,000 jobs.
Most countries outside the U.S., including all European countries, levy a VAT on goods and services, with tax rates in Europe typically around 20 percent. This is the primary source of tax revenue in Europe. If the U.S. were to introduce a VAT at a rate of 5 percent, it would generate $6.1 trillion of tax revenue over 10 years, while reducing GDP by 1.2 percent and eliminating about 900,000 jobs. After-tax incomes of the middle class would fall about 4 percent in the long run.
Another option is a carbon taxA carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them. , which is commonly used in Europe to reduce carbon emissions. Instituting a new tax on carbon at a rate of $60 per metric ton would generate $2.3 trillion of tax revenue over 10 years, while reducing GDP by 0.4 percent and eliminating about 350,000 jobs. After-tax incomes of the middle class would fall by more than 1 percent in the long run.
None of these tax increases is popular, so it is no wonder they were not proposed as part of the BBBA. However, if enacted, the BBBA would exacerbate an already unsustainable debt path, eventually forcing serious consideration of European-style taxes on the middle class.
It should be noted there are two other fiscal outcomes in which such unpopular tax increases could be avoided, but neither is very likely to occur. First, government spending could be reduced, but there is not a lot of precedent for that in the U.S. or any other developed country. Second, the U.S. could inflate away a substantial portion of the debt by the Federal Reserve increasing the money supply (arguably already underway, but we are not yet talking about sustained high levels of inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. like we see, for example, in Turkey).
The currently elevated rate of inflation approaching 7 percent, partly attributable to current and proposed deficit spending, is enough to illustrate some of the dangers. More inflation would be worse, not only because it broadly reduces the buying power of U.S. consumers, but because it penalizes savers and investors, raising taxes through bracket creepBracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions—both at the federal and state level—are adjusted for inflation. and features of the tax code that are unindexed for inflation.
Ultimately, policymakers and taxpayers should understand the scope of tax changes necessary to fully pay for the large-scale social spending programs that would be initiated under the Build Back Better Act. It most certainly does not cost zero, and the costs will most likely be borne in large part by the middle class in the form of higher tax burdens, inflation, and reduced economic opportunities.
|Long-run GDP||Long-run Full-time Equivalent Jobs (millions)||Long-run After-tax Income of Middle Class||10-Year Static Tax Revenue ($ trillions)|
|Add a Flat Individual Income Tax of 5%||-2.1%||-2.2||-4.4%||$6.5|
|Raise Individual Income Tax Rates by 10%||-0.9%||-1.0||-1.1%||$2.1|
|Replace Brackets with a Flat 20% Tax Rate||1.3%||1.2||-3.3%||$1.1|
|Eliminate the SALT Deduction||-0.7%||-0.5||-0.8%||$1.6|
|Eliminate the Mortgage Interest Deduction||-0.7%||-0.4||-0.9%||$1.1|
|Increase the Payroll Tax by 3 Percentage Points||-0.5%||-0.5||-2.9%||$2.0|
|Enact a 5% Value-added Tax||-1.2%||-0.9||-4.0%||$6.1|
|Enact a $60 Per Ton Carbon Tax||-0.4%||-0.3||-1.4%||$2.3|
Note: Middle class defined as the middle quintile of income earners.
Source: Tax Foundation General Equilibrium Model, May 2021.