CRISIS OR OPPORTUNITY FOR U. S.?
President Obama could now be in the driver’s seat to reform Bush- era tax laws without forcing the country into a recession
Major changes to current U. S. tax and spending law are needed to put the government budget on a sustainable path. Debt held by the public as a share of GDP has risen sharply since 2001 when the budget was in surplus. The shift from a surplus to a deficit position and the subsequent rise in the public- debt- to- GDP ratio are largely attributable to the Bush- era tax cuts, the deficit- financed wars in Iraq and Afghanistan, and the recession. The ratio now stands at roughly 73 per cent of GDP — the highest level since 1950 and about twice the level seen at the end of 2007 before the financial crisis and recent recession began. Current law — the fiscal cliff — would drive the deficit and debt down dramatically. But it would cause a recession and significant loss of jobs. Both Democrats and Republicans agree they must address the fiscal challenge, but they must do so prudently to minimize the economic risks.
The fiscal cliff has filled the media vacuum created by the end of the election coverage. The problem is that too much austerity is slated to come on Jan. 1, amounting to roughly $ 655 billion in fiscal tightening, representing 4.1 per cent of the economy. If allowed to stand, this would throw the U. S. economy into recession and cost at least 3.5 million jobs according to the Congressional Budget Office ( CBO). The CBO estimates could, in fact, be well off the mark because the multiplier and psychological effects of such large tax increases and spending cuts are unpredictable. As well, we don’t know how the financial markets would react to a foray off the cliff. Some analysts and politicians in the EU had argued that austerity would boost markets because of the positive impact on debt and deficit reduction, but Europe’s recession has proven them wrong.
The uncertainty surrounding the fiscal cliff has already slowed U. S. growth by reducing business confidence, causing the postponement of capital spending and hiring. The sooner this austerity crisis is resolved, the better. But it is unlikely to be fully resolved by the lame- duck Congress. Tax reform takes time, as do compromises on the spending side. Lawmakers could delay the tax hikes and spending cuts for the new Congress; but, regardless of when and how a compromise is reached — it will be reached because the consequences of failure are so dire. Every Congressman faces the voter in just two year’s time; inevitably, fiscal policy will be tightened via some combination of tax hikes and spending cuts, creating a head wind for the U. S. economy.
Fiscal policy has already tightened by virtue of the end of the Obama stimulus, the cuts in defence spending in Iraq and Afghanistan and the decline in government employment. The contraction in total government spending slowed the economy in 2011 and this year as well, in part attributable to the cuts at the state and local level. The CBO assumes that most of the Jan. 1 austerity measures will be prevented by lawmakers and hence has prepared projections under what they call “the alternative fiscal scenario.” Even under this scenario, however, they assume the payroll tax holiday will end, amounting to $ 113 billion of fiscal tightening or 0.7 per cent of GDP. In addition, the new taxes from the Obama health care law will also remain, but they are small, representing only 0.2 per cent of GDP.
The biggest sticking point is on the tax side. In the debt- ceiling battle of August 2011, the most contentious issue was the Republican ( Tea Party) refusal to increase taxes. As well, Mitt Romney ran on a platform of tax cuts, but broadening the base by reducing tax expenditures ( itemized deductions). Some Democrats and the White House recently have suggested support for a cap on deductions ( at 29 per cent of income), but that in itself will not raise much money, relatively speaking. According to the Tax Policy Center, the 29 per cent deduction cap would generate $ 164.2 billion over 10 years if the Bush tax cuts stay. By comparison, letting the Bush tax cuts expire for incomes above $ 250,000 would generate close to $ 1 trillion.
The President’s first salvo is calling for an increase in taxes of $ 1.6 trillion over the next decade which, he contends, must include an increase in tax rates for those with incomes of $ 250,000 and above. The early response by House Republicans is to reject this proposal. But this time, the President has the mandate of the election result as he campaigned strongly for tax rate increases for high- income earners. No one could argue that the U. S. is a high- tax country, both relative to its historical average or relative to other countries.
Despite the propaganda from some sources, the long- term fiscal problem of the U. S. is principally that revenues are too low. The Bush tax cuts were much less effective than the Reagan cuts because they were always temporary. Obama agreed to extend them in 2010 to avoid a fiscal cliff Jan. 1, 2011, caving into Republican intransigence. He had no choice because the economy then was too fragile to support a tax increase. But he said at that time and throughout the campaign that he would not extend them again for high earners.
The economic and political dynamics now are very different than they were in 2010 when Republicans were coming off a huge midterm electoral victory; this year they have suffered a huge political defeat. Support is wavering on Grover Norquist’s AntiTax Pledge. According to a report in The Hill, the Capitol Hill newspaper, incoming members of Congress and even a few returning ones are refusing to honour it. Staunch refusal to raise tax rates will cause a gridlock that can no longer be afforded. But changing the tax code rather than raising tax rates could work as well.
There are the makings of a deal here. In exchange for higher taxes on the rich, President Obama should pledge support for a grand bargain to simplify and reduce corporate tax rates and reform entitlement spending. The President already agreed to entitlement spending reductions in the summer of 2011 and he got Nancy Pelosi and Harry Reid to back them. In August 2011, the President agreed to squeeze $ 250 billion from Medicare in the next 10 years, with $ 800 billion more in the decade following. He was willing to cut $ 110 billion more from Medicaid in the short term.
Consideration should be given to the actions that would have the biggest budget gain with the least damage to the economy.
Fiscal tightening is essential, but the goal is to mitigate the blow to the economy as much as possible. The wrangling will be difficult and sometimes seem hopeless, but this time a deal will be done.