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Eight Common Sense Suggestions for the Fiscal Discussions

Charles Blahous | 12/05/2012

Thus far the parties’ respective positioning on the “fiscal cliff” has produced little agreement. President Obama’s proposal to raise taxes by $1.6 trillion without significant reductions in spending growth has been rejected by Republicans. The White House in turn quickly rejected the House Republicans’ counter-offer to enact a solution similar to the bipartisan Bowles-Simpson commission proposal. Concerns are rising that elected officials will be unable to reach a deficit-reduction deal before we go over the cliff at year’s end. With the parties so far apart, renewed attention to basic common-sense principles is perhaps in order.

Point #1: There is no point in complaining about others pushing for their policy views. President Obama, having just been re-elected, should be expected to use the full power of his office to advance his preferred policy outcomes. Congressional Republican leaders, too, should be expected to use the full powers of their continuing offices to advance their preferred policy outcomes. No one can force another to support something they believe is against the nation’s best interests. For a negotiated solution to be enacted, the negotiators must be persuaded it is better than the available alternatives.

If House Republicans conclude that the President is adopting an unreasonable position, they can pass their preferred alternative and declare themselves ready to negotiate in conference. If the President finds such a House-passed solution unacceptable, he can declare his intention to veto it and work with the Senate Majority Leader to pass an alternative there, setting up a conference with the House. All of the various elected officials have constitutional roles to play, so everyone should get used to them being played. No one can settle these disagreements by fiat.

Point #2: While the fiscal cliff is largely about taxes, the long-term deficit problem is about spending. The “fiscal cliff” refers to a host of current temporary policies scheduled to expire, as well as other spending cuts scheduled to commence, at year’s end. The discussion of a “grand bargain” on the debt is instead spurred by the realization that current policies if continued would create an unsustainable fiscal situation. These are related issues but are not exactly the same.

Taxes loom large in each discussion because pending tax hikes are a big part of the fiscal cliff and because the two parties are far apart on long-term tax goals. But there are other large distinctions between the two sets of issues. The fiscal cliff has no particular significance for Medicaid or Social Security, for example, though each program plays a big role in the long-term deficit outlook.

Specifically, under current law long-term fiscal strains are driven by spending growth.

Federal Expenditures are Growing Faster than the Economy
 Source: Congressional Budget Office

All of this projected spending growth is concentrated in four programs – Social Security, Medicare, Medicaid and the new health entitlement known euphemistically as “Obamacare.” No serious grand bargain on the budget can avoid dealing with these programs.

Long-Term Spending Growth is Driven by Four Programs
Source: Congressional Budget Office

Point #3: Advertised ratios of proposed spending cuts to tax increases are meaningless and should be ignored. Only the absolute levels of spending and taxes matter. One occasionally reads of “offers” to cut three dollars (or some other figure) of spending for every dollar in tax increases. These framings should be ignored because they mean nothing. They involve comparisons with imaginary alternative courses, and are typically riddled with gimmicks. They are produced to create a misleading impression of the actual amount of spending restraint in a fiscal bargain, and to exaggerate one’s own side’s policy flexibility.

To truly illuminate the effect of a budget deal, analysis should focus on the absolute levels of tax and spending that would result from it, and on the trend of those levels over time, rather than comparing to a completely fictional alternative course.

Point #4: Stabilizing spending is the best way to clinch any deal that includes revenue increases. There has been much press coverage of the pressure President Obama is attempting to place on Republicans to raise tax rates. All the pressure in the world, however, does not give conservatives an incentive to support tax increases as long as federal spending continues to rise as a share of the economy. As long as it does, conservatives know that any tax increase must ultimately be followed by another demand for more taxes at a later date. The quickest way to seal a deal with conservatives to raise revenues is to commit to stabilizing federal spending as a percentage of GDP.

Co-chair Erskine Bowles of the Simpson-Bowles commission realized this, which is why its recommendations would have stabilized long-term federal spending levels at 21% of GDP. There is nothing sacred about the historical average of 21%; the key is that spending can’t ultimately grow faster than the underlying economy can support. This week Republicans reiterated their willingness to raise revenues as part of a package that fixes the spending growth problem. Without such a fix, however, conservatives have little reason to agree to a significant tax increase of any amount.

Point #5: Federal deficits are reduced by tax revenues, not by tax rates. As the two parties jockey with each other over tax rates, let’s remember this common-sense observation: federal deficits are not lowered by tax rates but by tax revenues. There is little point in crossing swords over tax rates if the two sides cannot agree on broader revenue and spending goals. For some the rate argument carries political or distributional importance but it has little to do with solving the deficit problem.

Point #6: For a given amount of tax revenue collections, high marginal tax rates with many loopholes are bad economic policy relative to lower rates with few loopholes. Opposition to rate increases doesn’t exist solely because legislators signed an advocate’s pledge. Economists generally agree that it is better to produce a given amount of revenue with lower rates and few loopholes than with high tax rates and a lot of loopholes. Lower rates increase fairness, create fewer distortions, and better reward additional work effort. High rates with many loopholes are inefficient and corrupting, often serving as vehicles for legislators to steer tax preferences to politically influential entities. Even those who aim to “tax the rich” should strive to do it, to the extent possible, by taking away their tax preferences rather than by raising marginal rates.

Point #7: The logical way to hit the “rich” is to cut federal spending on them. President Obama has made a case that upper-income individuals should contribute more to deficit reduction. Republicans note that spending growth is the primary driver of deficits. These positions do not necessarily conflict. The rich can be made to contribute by reducing their government benefits rather than by raising their taxes. This would serve both parties’ goals simultaneously by requiring the sacrifices of those on the upper income end, while also directly addressing the spending at the root of the fiscal problem.

This approach would also be conducive to economic growth. High marginal rates are bad for growth because they deter additional work effort. Reducing the growth of Social Security and Medicare benefits for the richest Americans would instead promote additional work effort and economic growth because the rich would need to work more to make up for reductions in their projected retirement income.

Point #8: Any credible deficit-reduction deal must split the Democratic caucus and will likely need to be negotiated largely by President Obama and Republicans. It should be common sense that any deficit-reduction deal must reflect the views of those who believe the deficit is a real problem. This policy view is not shared equally across the political spectrum. Many influential progressive advocates dismiss the urgency of deficit reduction, and thus should not be expected to yield significant policy ground to enable it. President Obama will need to choose (if he hasn’t already) between pleasing the progressive wing of his party and building a deficit-reduction coalition.

No one outside the White House can know the mind of the President with certainty. If his goal is simply to raise taxes enough to avoid dealing with the long-term deficit drivers, he will not strike a deal with Republicans and instead hew closer to his party’s progressive wing. Only when there is a public break between the President and his party’s progressives will we know that he is making a serious play for a deficit grand bargain. This is not to claim superior economic policy virtue for those in the center and on the right. It is simply the nature of the deficit reduction issue and how it is prioritized in different parts of the political spectrum. A grand bargain is only possible between those who value deficit reduction as a priority.

It may already be too late in the budget negotiations for common sense to prevail. But if negotiators are serious about concluding a fiscal grand bargain, they would do well to observe these realities.

Charles Blahous is a research fellow with the Hoover Institution, a senior research fellow with the Mercatus Center, and the author of Social Security: The Unfinished Work.