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Advanced Economies Must Face Fiscal Reality

When advanced economies were growing rapidly, leaving greater debt burdens to future generations arguably was not a problem, because it was assumed that our children and grandchildren would be richer and thus capable of affording higher taxes. But stagnant productivity growth has made deficit-financed welfare spending indefensible.

STANFORD – Around the world, advanced economies are facing heightened fiscal challenges, owing to the simple fact that most have bloated, financially unsustainable welfare states. As Mario Draghi said over a decade ago, when he was serving as the president of the European Central Bank, “The European social model is already gone.” Equally, America risks falling into the same trap if it doesn’t control spending and rein in public debt.

The math is straightforward. Consider the case of welfare-type social benefits that are financed by payroll taxes. The average payroll-tax rate needed to cover such spending (now or later with interest, if financed with government debt) is equal to the dependency rate times the replacement rate – that is, the ratio of benefit recipients to taxpaying workers multiplied by the ratio of average benefits to average wages being taxed.

This equation does not even include the taxes needed to pay for other government-funded programs, from defense and policing to roads and schools. Yes, other kinds of taxes can be used to cover these costs, and various changes can be made to the benefit formulas and tax schedules. Ultimately, though, if you have many people receiving considerable benefits, you will (eventually) have very high tax rates. As Shakespeare’s Hamlet mused, “aye, there’s the rub.”