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Sorry, middle class. The VAT may be inevitable.

January 14, 2013: 10:21 AM ET

If the government fails to enact structural reforms in spending, an entirely new source of revenue will be needed. The most likely one is a value-added tax that would crush the middle class.

 FORTUNE -- You can't blame middle-income Americans for wondering whether the new "fiscal cliff" deal really protects them from big tax increases in the future. That's essentially what President Obama promised in championing the hike in rates for high-earners signed into law on January 2. Still, the politicians and pundits keep talking about how our steep deficits and mountainous debt will rise even after the new revenue is counted. So it's only natural for the folks to ask the obvious question: Now that the affluent are paying far more, where's the extra cash supposed to come from?

The answer is that America's teachers, nurses, truck drivers, police officers, computer programmers and construction workers should indeed be worried. To understand why, it's important to carefully analyze the most likely trajectory of tomorrow's budgets. To get the best view of our fiscal future, I spoke to Congressional aides who recently prepared new forecasts incorporating projected receipts from the recent tax increases. Those projections closely track the numbers prepared by the non-partisan Congressional Budget Office in March and August of last year, when the fresh revenues from high-earners are included.

On January 4th, the CBO posted a blog predicting that the new legislation would lower deficits over the next decade by a modest $600 billion to $700 billion, compared to the projected shortfall if all the Bush tax cuts remained in place. The forecasts in this story generally reflect that estimate.

Charting the path of future spending and revenues points to four conclusions. First, over the next several years, the numbers that are now so troubling, including deficits, debt and spending as a share of GDP, may substantially improve. That's by no means certain, since it depends on a convergence of low interest rates, a strong economy, and other unpredictable factors. But it's highly possible, or even likely.

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Second, this interim period of calm will not last long. By 2018, the budget picture -- in the absence of major structural reforms to entitlements -- will start unraveling at shocking speed. Anticipating disaster, global investors could shun U.S. Treasurys and drive up interest rates, igniting a crisis.

Third, the budget-blowup scenario can only be averted by starting to reform Medicare and Social Security soon, since waiting eight or ten years would require lowering a hammer on a new bulge of baby boomers who will by then either be receiving benefits, or getting close to eligibility. So the longer our politicians wait, the more politically difficult, and more unlikely, entitlement reform becomes.

Fourth, if America fails to enact historic, structural reforms in spending, an entirely new source of revenue will be needed. And it's likely to be enacted in haste and near-panic, as the only option to forestalling a crisis. "The gap between revenues and outlays will be simply too large," says J.D. Foster, an economist at the conservative Heritage Foundation and a former budget official under President George W. Bush. "Three points of GDP need to be closed to make budgets sustainable. Either government spending gets back near where it used to be, or we'll need an completely new type of tax."

The new levy will need to be big, so big that the most probable choice is a European-style value-added tax or VAT. That looming revenue machine is the phantom in the room, the tax that's still invisible to most Americans, but that threatens precisely the group that's supposed to emerge from all the deal-making as the Great Unthreatened, our middle class.

As background, it's important to understand the current fiscal picture, and how it limits our freedom to maneuver in the future­ -- especially because borrowing levels are already so high. Today, government spending is running at almost 23% of GDP, compared to an average of 20% from 1989 to 2008. Because of the meager expansion, tax revenues have fallen to 16% of national income, far below the long-term average of over 18%. The shortfall has saddled us with a near-7% budget deficit, and driven the burden of debt-to-GDP to 73%, well below European levels, but nearing the danger zone.

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Here's how the picture is poised to brighten. From 2013 to 2017, tax revenues will rise sharply. The catalysts are the continuing recovery, and the new taxes on the affluent. At the same time, spending should be tightly controlled because of one overriding factor: A gigantic fall in "discretionary" outlays, funds that need to be appropriated each year, everything from defense spending to the budget for the Department of Education. One forecast by a respected Congressional aide predicts that discretionary outlays will drop from 7.7% to just over 5% by GDP over the next decade. That's a decline of as much as 20% adjusted for inflation.

The reason the spending numbers are plausible is because the Sequestration Act of 2012 requires big, automatic reductions in defense and other discretionary outlays. The Republicans won't abandon Sequestration without big reforms to entitlements, a possibility that looks increasingly remote.

To be sure, this scenario assumes that the economy grows at a robust 4% from 2014 to 2017 and that interest rates remain subdued. If that favorable climate prevails, spending in 2017 will drop to 21.5% of GDP, deficits will shrink to around 3.5%, and debt will stand in the mid-70% range, not far from today's figure.

The descent starts in 2018. In the absence of entitlement reform, it's totally predictable, fully quantifiable, and extremely steep. Spending will start to explode as an aging population swells Social Security and Medicare benefits, at the same time revenues remain flat as a share of national income.

Revenues won't save the day. The forecast I'm using foresees receipts of 19.6% of GDP in 2018, well above the historical norm. Neither Republicans nor Democrats think that revenues can rise beyond that level with the current tax system that's heavily dependent on income taxes. In other words, we'll run out of room to raise more money.

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As revenues rise with the overall economy, and no more, expenditures soar about 0.4% a year faster than GDP -- for many, many years to come. By 2028, spending would absorb close to 25.5% of national income. Without tax increases or action on entitlements, debt-to-GDP would exceed 100% and soaring interest payments would threaten America with insolvency. This is the definition of a chronic, structural deficit, one that isn't caused by a recession, and persists even when growth is robust.

To avoid a crisis, taxes would need to start rising sharply in the middle part of this decade. The U.S. can support 3% budget deficits without a disastrous increase in debt, since the economy will potentially grow at that rate. So by the mid-2020s, we'd need to have a system in place that collects an extra 3 points of GDP in revenues. That's the 25.5% spending rate, minus around 22.5%, approximately representing the 19.6% share of revenues plus the 3% deficit.

How big is that number? By 2028, it would total around $1 trillion. Raising an extra $1 trillion would require a 37% rise in income taxes. Hiking tax rates on anyone, high-earners or the middle class, won't remotely collect that kind of money. Once again, the 19.6% of GDP is about the limit of what the current tax system can provide, given that marginal tax rates far higher than today's have seldom collected more than that share.

It gets worse. To hold deficits at 3% of GDP, revenues, meaning tax receipts, would need to rise by 5.4% a year, by my calculation. That's 5.4% after inflation, assuring a ballooning of the public sector and a shrinking of the private economy that funds it.

This crunch may not happen. Sweeping new measures that slow the growth of entitlement spending is the sole alternative. To work, the reforms need to start soon. By 2019, all baby boomers will be age 55 or older. America will be running out of time for reform. Curbing Medicare and Social Security at that point would mean slashing benefits from tens of millions more Americans who will already depend on monthly checks and affordable medical care, or are counting on those benefits in a few years (eligibility for Social Security starts at age 62). The appeal of leaving today's benefits in place for folks nearing retirement, a staple of all reform plans, would be gone, greatly diminishing the opportunities for an overhaul.

MORE: Good luck estimating your new tax rate!

If Washington gridlock persists, the big new tax is a virtual certainty. The most probable choice will be a VAT. Since the VAT is assessed on things people buy, not their incomes, it falls heavily on the middle class. Suddenly, the issue is sneaking into the fiscal debate. A January 7th editorial in the New York Times called for a VAT. The same week, in a piece criticizing the nomination of Jack Lew for Treasury Secretary, the Wall Street Journal editorial page groused that President Obama's spending plans will saddle America with a VAT by default.

This isn't what the middle class was promised. But the numbers, even assuming good days ahead for the economy, point inexorably in that direction. We don't know what crisis will enable the phantom to take charge. But every day of inaction brings that crisis nearer.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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