One salient aspect of America’s collective anxiety over the financial crisis is, of course, the deficit. The nascent “Tea Party” movement has tapped into this anxiety and made it a central thesis of their supposed revolution. Leaving aside for a second the Tea Partiers’ refusal to acknowledge the $5 trillion increase in the Federal debt that occurred under George W. Bush and the fact that they seem hopelessly incapable of suggesting a single rational solution to a problem they consider so devastating, the national debt is a potentially catastrophic problem that needs to be dealt with.

Being outsiders, the good people at The Economist typically view America’s problems without the passions and prejudices that currently obscure our nation’s political discourse and allow it to conduct sophisticated analysis. This month they’ve done so again in regards to this deficit conundrum. Let’s get a few things out of the way right up front. Some of the typical deficit boogeymen are in reality insignificant to the cause of our deficit and any potential solution. Earmarks? Sorry, less than one-half of one percent of the annual budget. Bailouts? They hurt, but a lot of that money has been paid back, more will be paid back, and those were one-time charges that aren’t going to be appearing year after year until 2050. No, the real “giant vampire squids” wrapped around the face of our humanity are the entitlement programs, Medicare, Medicaid, and Social Security. Throw in exorbitant military spending and a host of misguided tax deductions and voila, you have our long-term fiscal nightmare.

Or more specifically:

Using the CBO’s economic-growth and interest-rate assumptions, and assuming that Mr Obama’s last budget is implemented (for example, that his payroll-tax credit is made permanent and that George Bush’s tax cuts remain except for the wealthiest), a deficit of 3% of GDP in 2014 (instead of 4.2%) would stabilise debt at about 70% of GDP. That would require trimming more than 200 billion from the 2014 deficit and more than 500 billion from the 2019 shortfall. This amounts to a cumulative 1.2% fiscal contraction over three years, and about double that over seven.

Alright, which leafs do we decide to prune? Well we’ve got those haphazard old geezers called The Baby Boomers to take care of, with entitlements going from 10% of GDP (and nearly 40% of the overall budget) to 18% by 2050.  The health plan being enacted is painstakenly budget neutral, but that still prevents certain cuts from reducing the overall deficit instead of maintaining neutrality.

One sensible move on Social Security and Medicare could be to increase the qualifying ages. Life expectancy has increased, lengthening the era of a person’s productivity. Entitlements are in place to provide for those who cannot provide for themselves, so I see no reason to allow people to begin collecting entitlements at the same age that they did when life expectancy was 10 years shorter.

On Medicaid, the Federal Government covers the overwhelming majority of payments, giving the states no incentive to cut down on costs. The Economist suggests switching to a system of block grants, forcing states to monitor their Medicaid spending and allowing wealthier states to carry more of the burden. This proved successful with welfare reform in the 90’s. Defense and “discretionary” spending account for 1/3 of the budget. Assuming Iraq and Afghanistan can be phased down over the next 2-3 years and discretionary spending is capped and indexed for inflation, we can carve $160 billion out of the deficit over the next decade, on top of whatever annual cuts are made to the military budget (not hopeful that will be a significant figure).

Now that brings us to the revenue side, taxes. Word on the street is that Obama has former Fed Chairman and stagflation-whipper Paul Voelcker cooking up a monolithic tax reform plan to be released at next year’s State of the Union. What can we be in store for? Maybe an end to bare-naked loopholes and deductions subsidizing self-destructive industries? The mortgage interest deduction and deduction of employer-provider health insurance do come to mind. I’m all for home ownership and a healthy housing industry, but there’s simply no justification behind such a massive deduction for mortgage interest. All it does is encourage more debt and I think we can all agree that the massive de-leveraging that is underway was long overdue.

Abolishing deductions for employer-provided health care, mortgage interest, capital gains on homes and state and local taxes would raise over $500 billion in 2014.

“Abolishing” might be a more radical term than the American economy can withstand. “Reducing” sounds a little more pragmatic and it does seem realistic that we can squeeze a couple hundred billion in savings from a reduction of these subsidies. A consumption tax (or Value Added, VAT, Tax) seems simple and effective, although I can’t imagine the next few years are when we want to start punishing any behavior that leads to consumer demand (other than debt, of course). Nevertheless, The Economist predicts such a 5% tax on consumption (excluding housing, education, and charity) would raise over $300 billion by 2014.

This is a greater problem than this humble blogger can solve and I’m sure glad we have smarter people than moi working on the solutions (uh, I hope). So on closer glance, tackling our deficit problem appears quite similar to Michael Corleone’s conundrum of killing Hyman Roth: “Difficult. Not impossible.”