Fiscal Precipice or Opportunity?

By Bill Apfel
From the Winter 2012 Edition of Values


Deficit hawks should be rejoicing. Congress and the Administration set a deficit-busting trap for themselves during 2011’s debt ceiling debate. Failure to craft a “grand bargain” to close the deficit triggered a plan to do the work that the politicians could not: If Congress or its “super committee” did not break the stalemate, the Bush tax cuts would expire and across-the-board spending cuts would occur automatically. The date for implementation is January 1, 2013, conveniently after the 2012 elections.

The day of reckoning is now near. If Congress cannot agree on changes, the projected $1.1 trillion federal budget shortfall for 2013 will be cut in half. Three-quarters of the reduction comes from tax increases; one-quarter from spending cuts. The latter would hit the defense budget most severely. A coincidental deficit-hawk-pleasing bonus barely reported in the press but of great importance to working Americans also looms: The temporary” two percentage point reduction in payroll taxes, estimated to cost $126 billion annually, was already slated to expire at year-end.

But no one is cheering now about the charted deficit reduction path. Call it Keynesian economics or just common sense—if taxes go up and the government spends less, the economy will weaken and fewer people will be employed. The Congressional Budget Office forecasts that the economy will slide back into recession and the unemployment rate will rise to 9.1 percent by the end of 2013. In contrast, if current policy were simply extended, GDP is forecast to rise 1.7 percent and unemployment hold steady. The latter projection doesn’t even include the added benefit of retaining the payroll tax relief. Forecasters estimate that move would add another 0.5 percent to growth.

Now a lame duck Congress and the reelected Obama administration are confronted by a crisis of their own making. And it’s a fair question to ask whether it makes sense to worry about the deficit anyway. Despite the frightful talk about the United States following Greece down the path of insolvency, government borrowing rates have never been so low and inflation is modest. If you postulate that this is all because the Fed is distorting the market by printing money, you need to explain why the international value of the
U.S. dollar remains strong. Might the government default if the debt keeps piling up? Not unless Congress willfully causes it. The United States, after all, only issues debt in its own currency and the Fed can supply that without limitation.

Given the consequences, both economic and political, it’s unlikely that our leaders will send us over the so-called “fiscal cliff.” Message number one to our leaders must be to do no harm. In the short-run, even current policy is preferable to the austerity trap that was born of expediency 18 months ago. Important issues, however, are at stake. Large deficits may be appropriate when the economy is weak, but if we are once again to have an economy operating at full capacity, deficits will drive inflation and interest rates higher and stall investment. The difficult questions thus remain. What are the appropriate responsibilities of government, and what is the best way to pay for them? The fiscal cliff may be the outcome of a broken process, but it should compel a first step in confronting these issues.

Let’s take taxes first, since they have been the biggest near-term barrier to a budget compromise. If current laws are extended, tax collections in 2013 are projected to equal 16 percent of GDP, far below spending of 23 percent of GDP. It is impossible to know for sure to what degree revenues can be lifted without curtailing growth. It is clear, however, that some approaches entail a smaller growth penalty than others. There is virtually no evidence, for instance, that modestly higher taxes on the very richest Americans will have much impact on growth.

We don’t need to quibble too much about the means to increasing the tax take from the wealthy. Reasonable approaches that should be acceptable to both sides have already been proposed. Mitt Romney’s late campaign suggestion that federal tax deductions be limited to $25,000 would be even more progressive than the Obama administration’s proposal to limit the benefit of deductions to the 28 percent tax bracket. Estimates are that Romney’s plan alone could raise $100 billion annually. Similarly, higher rates on capital gains and dividends might raise $25 billion per year and would do little to curtail growth. An increase would surely be better received if coupled with a growth oriented reduction in corporate tax rates. A minimum tax on the highest earners, advocated by Warren Buffet, might raise an additional $15 billion annually while avoiding much of the controversy regarding the merits of specific tax breaks.

Some tax increases, however, would severely damage the economy while falling most heavily on those least able to afford them. Ironically, despite the campaign rhetoric about protecting the middle class, the scheduled increase in payroll taxes has received barely any attention from either political party. It would hit the average two-income family most severely, raising their annual tax bite by $1500 or more. Unlike higher taxes on wealthy Americans, higher payroll taxes can be expected to directly reduce consumer spending. There should be plenty of room for compromise on this issue. A more modest payroll tax hike makes economic—and political—sense.

Spending trends are more difficult to address than tax increases—a fact that explains the paucity of proposals made by politicians. Choices here reflect deeply held convictions regarding the responsibilities of government, a subject too vast to be addressed here in detail. But some points should be straightforward. Simple-sounding goals like limiting government spending to the 1990s average of about 20 percent of GDP fail to address the choices they imply. America’s aging population and the persistent increase in the cost of healthcare have changed the math. Medicare, Medicaid, and Social Security today account for over 45 percent of federal spending. (Defense accounts for another 18 percent). Assuming current policy, these programs will absorb nearly 60 percent of outlays in 10 years and 70 percent of revenues if new funding sources are not found.

Social Security is the more manageable program. Current funding is not hopelessly out of sync with expected outlays and there are straightforward choices that can be made to reduce costs: Benefit formulas can be adjusted to slow growth, the eligibility age can be raised, and benefits can be means tested. The fairness and efficiency of each alternative can be debated, but the challenge is manageable.

Healthcare spending is a far greater challenge. Unless we choose to deny care to those who can’t afford it, slowing the growth in costs means difficult choices regarding how to allocate services. Greater efficiency is a worthy goal, but it is unlikely to be sufficient. Shifting more of the burden to employers by increasing the age of Medicare eligibility will make the federal books look better, but the expense will not be avoided and the impact on economic growth would probably be just as great. At current trends, healthcare is projected to consume 50 percent of GDP by 2082, the great bulk coming from the rising cost of care rather than demographics.

Congress and the administration may have blundered to the edge of the fiscal cliff in order to avoid tough decisions before the 2012 elections. The election is now behind us. It should not be too much to hope that a compromise forged by cowardice forces a process that enables a healthier economy and long-term budget balance.