The debt limit has been raised repeatedly over the years. Prior to this week, the ceiling was US$14.29 trillion.

In May, the US Treasury Department said that the debt limit had been reached, but said that it could keep the government functioning normally by 'extraordinary measures' that would run their course by Aug 2.

If by Aug 2, US lawmakers still couldn't reach an agreement to raise the debt ceiling, the US government would run out of money to pay its bills, including interest on its existing debt. That would be catastrophic for the world financial markets.

Well, that crisis was averted. Late on the night of July 31, President Barack Obama and congressional leaders of both Democrat and Republican parties announced an agreement that would raise the debt ceiling by up to US$2.4 trillion in two stages. That would be enough to keep borrowing into 2013. The pact called for at least US$2.4 trillion in spending cuts over 10 years, with US$900 billion in across-the-board cuts to be enacted immediately.

Rising spending

What has brought the US to this state of indebtedness?

From Chart 1, you can see that spending by the US government has been rising steadily since 1990. But the pace picked up in 2003. It further escalated in 2009 and 2010.

Healthcare, pensions, education and defence were the four biggest categories of spending by the US government. Spending on healthcare has risen by 7.9 per cent a year since 1990, while that of welfare has increased by 7.4 per cent a year.

Overall, spending has climbed 5.2 per cent a year in the last two decades. In contrast, government revenue has risen by a much slower 3.9 per cent a year.

Up until 2007, government revenue more or less grew in tandem with government spending. But collections dropped off in 2008, 2009 and 2010 following the global financial crisis.

Chart 2 shows US government spending and revenue as a percentage of the country's gross domestic product (GDP). In 2009 and 2010, the revenue collected by the US government was less than 30 per cent the country's GDP. Spending, meanwhile, exceeded 39 per cent of GDP.

All of the shortfall was funded by debt.

Chart 3 shows the various components of spending and Chart 4, the sources of government income. From Chart 4, you can see a sharp drop in the income tax collected in 2009 and 2010.

Anecdotally, we've read of huge US corporates making billions of dollars in profits but paying only minuscule sums of taxes. I wanted to find out, in aggregate, if the debt burden of companies has indeed declined over the years.

So I downloaded the revenue, cash from operations, free cash flow and cash paid for tax for the S&P 100 companies from 1996 till 2010.

From Chart 5, you can see that the debt burden of US companies has fallen sharply since 2008. In 2009 and 2010, these companies paid 16 per cent and 19 per cent out of their cash flow from operations as taxes. The average in 1996 to 1999 was 22.6 per cent.

Some companies got away with paying negligible taxes. For example, data from Bloomberg showed that Xerox paid US$49 million cash in taxes in 2010. This compared with its cash flow from operations (CFO) of US$2.7 billion that year.

Verizon Communications forked out US$430 million of taxes on CFO of US$33.4 billion. That's just 1.3 per cent of the cash it generated.

The result is the US government has to borrow to fund its spending. Since 2009, its gross public debt has exceeded its GDP.

The recent deal called for spending cuts, US$900 billion of which was to be enacted immediately. Such cuts in an economy that is still fragile pose the risk of it being a 'recovery killer'. The massive selldown in global equities yesterday is investors' way of showing their concern for that eventuality.

Reform hence has to be implemented on the revenue side. The US is the only major country without a national value-added tax and its sales taxes are the lowest in the Organisation for Economic Co-operation and Development (OECD). Likewise, US fuel and sin taxes are at the bottom among rich countries. And generous tax breaks mean many businesses and individuals pay little taxes, placing a heavy burden on a relatively narrow tax base.

Hence, the US has the fiscal capacity to raise taxes, unlike some of the European countries.

Simple solution

The solution is simple enough on the tax side, at least on paper, The Globe and Mail quoted Gary Hufbauer, a senior fellow at Peterson Institute for International Economics in Washington and a former top tax official at the Treasury department, as saying. The country must expand the tax base on individuals and businesses, eliminate many tax breaks, introduce a national value-added tax, raise fuel taxes and impose 'user fees' on a whole range of things, including parks, highways, airports, smoking and drinking.

On the corporate side, Mr Hufbauer pointed out that US tax rates are high by international standards, but special corporate entities created by Congress dramatically shrinks the corporate tax base. While business taxes average 22 per cent of GDP in the OECD, the ratio is just 13 per cent in the US.

Carefully crafted tax increases offer a relatively easy way out that could mitigate the economic damage caused by draconian spending cuts and reverse income inequality between rich and poor.

Said Chuck Marr, director of tax policy at the Center on Budget and Policy Priorities in Washington and a former economic adviser to Bill Clinton, and former Democratic Senate majority leader Tom Daschle: 'Tax increases are the only way to ensure that high-income households pay a fair share of the deficit burden. Without higher taxes as part of the fiscal-reform package, middle and low-income households, which tend to feel spending cuts most acutely, will end up bearing almost all of the burden.'

But politics gets in the way. Republicans have made a 'no tax' pledge to its voters. Hence, the tax option has become a political stumbling block in the Republican-controlled House of Representatives, as have deep spending cuts in the Democratic-held Senate.

Hopefully, the rich American voters can soon be persuaded of the good sense in being generous for the sake of the global economy. They too will not be spared if the world enters a severe recession.