Entitlement reform and tax structuring

Good news. Instead of simply trading demands of "Cut spending!" and "Raise taxes!" President Obama and leaders of Congress are now discussing both entitlement reform and changes in the tax structure. Let's look at each of them.

Entitlement costs — which constitute the largest component of government spending — are tied to demographic trends. If you pass a law that says that everyone over 65 is entitled to a certain payment, and the number of people who reach 65 goes up by 50 percent, the cost of the total program automatically goes up by the same 50 percent. Raise the payment to each individual and costs go up even more. That's what happened in Europe and is happening here.

Tax revenue, on the other hand, is tied to the economy. When it is bad, tax revenue goes down; when it is good, tax revenue goes up. Tax rates that go so high that they discourage economic activity actually reduce revenue. Finding the "sweet spot" where taxes create minimum economic drag and produce maximum governmental revenue is a trick that no one has ever mastered.

At the federal level, we have two principal tax systems — the payroll tax, which is paid by everyone who draws a paycheck, and the income tax, which is paid by only the richest half of Americans.

Payroll taxes were created to cover the cost of Social Security, the first entitlement. They were later used to pay for Medicare as well. When Medicaid and other health programs came along, excess money in the Social Security Trust Fund was used to cover part of their costs, but Social Security is now paying out more than it is taking in, and the government has to repay that money.

The costs of these growing entitlement programs have to be covered by the income tax, which was revised during the Great Depression primarily as a way to "share the wealth." Its graduated scale of brackets originally topped out at 93 percent.

Since that obviously stopped high earners from working harder — who would try to earn an extra $100 when he could only keep $7? — Congress created a series of exemptions ("loopholes" to some) to maintain economic incentives where they were needed. Subsequent Congresses have been furiously tinkering with exemptions and brackets and rates ever since, with dubious results.

So, "Cut spending!" won't balance the budget unless we revise entitlements. Cut the individual benefit promised to future generations, cut it for rich people, raise the age at which it will be paid or devise some logical combination of all three.