Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

6 Ways Washington Could CloseThe Deficit Now -- If It Had The Guts

It's agreed: We want the yawning American budget gap to disappear. But there is wide disagreement about how to make that happen. Smaller government? Higher taxes for the rich? Actually, there are solutions no one is talking about -- solutions that may surprise you.

To give you a framework of the kinds of choices that will need to be made, it helps to look at the current stance of both political parties. Broadly speaking, leading Republicans are committed to a smaller government -- without any tax hikes. Democrats, for their part, have suggested that for every $10 in government spending cuts, it's prudent to add at least $1 worth of new revenue sources -- i.e. higher taxes. Signs are emerging that a mix of both -- heavily skewed toward budget cuts -- will emerge, perhaps along the lines of the not-quite-dead Simpson-Bowles plan, which you can read about here.

When that plan was released in late 2010, it quickly became a political hot potato because it spelled out some tough moves with which neither side wanted to be formally associated. Courage has never been a key virtue of Washington's lawmakers.

Still, these tough measures are coming anyway, and even as both sides agree to compromises, few will be completely happy with the outcome.

For a bit of context, let's look at the various ways the budget gap can be closed and the likelihood of each option being pursued.

1. Eliminating individual tax deductions.

Roughly 18 months ago, I looked at the various tax breaks that consumers get, along with a gauge of how likely these breaks are to be reduced or eliminated.

As I noted, these deductions cost the U.S. Treasury $700 billion every year, which works out to be more than 75% of the current budget gap. Getting rid of them would almost bring our budget into balance. Yet as I noted, eliminating the mortgage interest tax deduction is unlikely, as it enjoys broad middle-class support. And besides: the housing market is still far too tenuous to handle another big headwind. Losing this tax break would change the economics of a home purchase, and home prices would have to fall to compensate for the lack of tax benefits.

On the other hand, those other tax deductions -- charitable giving, state and local taxes and the Earned Income Tax Credit -- are more likely on the table. The last one likely would be a key target if Mitt Romney were to win the upcoming election.

Still, it's fair to assume that some of these cherished deductions will not be part of your future tax planning.

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2. Cutting corporate loopholes

The tax code has ample breaks for companies as well, many of which have become adept at exploiting every break they can. Take GE (NYSE: GE). Over the past four years, the industrial giant has generated a cumulative operating income of $64 billion but paid just $6.6 billion in taxes, or a little more than 10%. That's a far cry from the official corporate tax rate of 35%.

The parties share their view on the issue: That official rate of 35% is too high and needs to come down, perhaps to around 28%, but some loopholes also need to be closed. The key difference between the parties: Democrats would like to eliminate enough deductions to have companies contribute a bit more to the mix. Republicans would also like to close some loopholes, but only to the extent that it offset the total revenue drop that results from a lowered top rate.

As I noted roughly a year ago on our sister site, "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."

Just moving that figure back to 80% would help to shave the budget deficit.

What kind of loopholes are we talking about? Investment industry executives shielding their income by paying capital gains tax rates (of just 15%), credits for investments in research & development, deferred taxes on overseas income, deductions for domestic energy exploration and so on.

3. A national sales tax

Many countries slap a tax on all goods and services, known as a Value Added Tax (VAT). Such a move here has been untenable, especially as states already have their own sales taxes. Yet as I noted a few months ago, a group called thinks a VAT might be just what we need. Even a VAT of just 5% or 7% would raise hundreds of billions, though it's worth noting that FairTax and other conservative organizations would pursue a VAT only in exchange for sharply lower income tax rates, which wouldn't be as helpful in closing the budget deficit.

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4. Raising the gasoline tax

President Bill Clinton hiked the gasoline tax to 18.4 cents per gallon in 1993, and there it has stood for 19 years. The tax receipts are used to maintain our bridges, roads and transit systems, though they don't nearly cover the costs. Raising the tax on gasoline to 50 cents a gallon (which is 32 cents higher) would still be well below the $2, $3 or $4 that many European and Japanese citizens pay. Every 10 cents per gallon increase in gasoline taxes would close the budget gap by $20 billion, according to the Highway Trust Fund.

5. Capping Medicare and Medicaid benefits

This highly controversial move would impact many Americans but has the quiet support of medical economists that have looked at our nation's rising health care tab. Consider this stat: 1% of all Medicaid beneficiaries consume 25% of all Medicaid spending. We're talking about people with chronic illnesses who rack up hundreds of thousands of dollars. A Medicaid spending cap, for example, of $100,000 may seem like an inhumane move -- especially if it's a loved one of yours, but it may be necessary to move health care spending back in line with levels in European countries.

Another stat: More than half of the health care expenditures consumed for most Americans will take place in the final 30 days of their life as doctors work feverishly to keep patients alive for just a little longer. Who gets to decide when not to treat? Well, that's where the scary "death panels" phrase came up. It's an awfully squeamish topic but will likely be raised again if we can't cap our rising entitlement spending.

6. A Smaller Defense Department?

The United States spent more on defense in 2011 than the next 13 countries combined, according to Bloomberg.  Throw in the high levels of spending on the Department of Homeland Security, and it's pretty clear that we take our security concerns seriously. But a question should be asked: Can the Department of Defense shrink by 10% and still be the best fighting force in the world? Some defense strategists think so -- if we are willing to cut a few very expensive programs such as advanced jet fighters and are willing to reduce our military footprint in countries like South Korea. A 10% cut would save the government more than $60 billion annually.

The Investing Answer: The budget deficit may begin to shrink a bit as the economy grows. Rising government receipts come from higher levels of economic activity. Yet a smaller government -- along with higher government revenue through closed loopholes -- appears inevitable.  So you should start adjusting your long-term assumptions about the taxes you pay -- and the government benefits you receive -- right now.