December 23, 2012
Spending, Taxation, and the Fiscal Cliff
Spending, Taxation, and the Fiscal Cliff-Becker
A front page article today in the New York Times points out that around 1990 the Republican Party shifted away from an emphasis on balancing the federal budget to an emphasis on the level of taxes. I believe that this shift was in the right direction, and it is highly relevant in understanding the Republicans' position on what to do to prevent the so-called "fiscal cliff" in 2013.
Supporters of a balanced budget approach to fiscal policy want federal spending and revenue to be about equal to each other in the long run. This means that any long-term growth in the deficit and in the public debt should be less than the growth in GDP. By contrast, the level of taxation approach emphasizes that the levels of federal spending and taxation are the primary determinants of the effects of the federal government on the economy, including incentives to work hard, invest, and start businesses.
The level of taxation ultimately determines the size of government since no government can continue to spend substantially more than its revenues. Greater government spending may help stimulate an economy coming out of a major recession, although the absence of any clear stimulus to the economy from the Obama stimulus package raises serious questions about the ease of stimulating an economy with fiscal policy. However, the level of federal government spending also has major direct effects on an economy, such as through spending on medical care, defense, and subsidizing the production of ethanol. Greater government spending also tends to crowd out spending by the private sector on consumption and investments.
Concern about the size of federal spending is particularly relevant at this juncture since federal spending has grown substantially during the past 10 years, especially rapidly during the past four years. In 2007, federal spending was under 20% of GDP, while it rose to over 24% of GDP in 2012. Less than half of this increased spending has been due to the growth in government spending on medical care, social security, and defense, while the rest is the result of increased spending on many other programs. Since greater government spending is also the cause of most of the growth in budget deficits, even those who target budget deficits, let alone those who target total taxation and spending, might well expect most of the reduction in deficits would come from spending cuts (spread out over time) rather than from higher tax rates.
Concentration on the level and nature of taxation implies support for widening the tax base through cutbacks in various unjustified exemptions and deductions from taxable incomes. Many special treatments of particular incomes should just be eliminated. The two most important deductions from taxable income are interest on mortgages and charitable contributions. Deductions of interest on mortgages are hard to justify from an efficiency standpoint, while the case for deductions for charitable contributions is stronger. Still,probably a cap on total deductions would be the best way politically to limit deductions. Such a cap would mainly hit higher income persons, and would raise the effective marginal tax rate for some taxpayers, but it would generally improve efficiency in the economy's use of resources.
Many commentators have questioned how Republican members of the House could fail to support Representative John Boehner's "Plan B" that would raise tax rates only on incomes over $1 million. I agree that the suggested tax increase on such a small fraction of taxpayers is unlikely to have much of a negative effect on the economy. But by the same token, President Obama's compromise suggestion to raise tax rates only on incomes above $400,000 will also raise little additional tax revenue. This explains why the president also wants to raise taxes on dividends, capital gains, and estates, and reduce deductions.
The president is clearly in the political driver's seat after winning reelection in a major victory. In the end he will probably get something much closer to what he wants than what Republicans in Congress want to offer. However, this does not mean that a position that wants major cutbacks in government spending and opposes increases in taxation that are not due to tax reforms, is a sign of intransigence rather than a thought-through opposition to larger government and bigger taxes.
The Fiscal Cliff--Posner
The "fiscal cliff" refers to a federal law scheduled to take effect on January 1 that will rescind the Bush tax cuts and make other adjustments to federal tax laws, with the overall effect being to increase tax rates and at the same time slash discretionary federal spending, much of it defense spending, across the board. If the "fiscal cliff" takes effect and remains in effect, it is estimated that over a ten-year period it will increase federal tax revenues by about a trillion dollars and cut federal spending by approximately the same amount.
This would do wonders for the federal deficit (the annual increase in the federal debt), slashing it in half (by $200 billion) in 2013 and presumably in each of the subsequent years as well—or would it? The increase in the deficit since the 2008 financial crash has been due mainly to the depression (as I insist on calling the "Great Recession"—its political consequences alone may turn out to be as great as those of the Great Depression of the 1930s). The depression has reduced federal income tax collections (because people's incomes have fallen) and increased spending on unemployment insurance and other depression-fighting spending measures (the "automatic stabilizers," designed to smooth the business cycle by increasing tax revenue/reducing government spending in booms and increasing government spending/reducing tax revenue in busts). A substantial increase in taxes will reduce private spending, and in turn the production of goods and services and therefore employment, while reducing government spending will reduce incomes and so increase the depressive effect on spending of higher taxes; both the tax increases and the spending decreases will reduce disposable income. The overall effect may be to offset the deficit reduction that would occur if the "fiscal cliff" law would have no effect on disposable income and therefore on production and employment (and therefore on income and tax revenue).
The President has proposed to avert the fiscal cliff by replacing the fiscal cliff law with a new law, the main provision of which would be to rescind the Bush tax cuts for anyone earning less than $250,000 a year. This is opposed by conservative Republicans on the ground that the President is proposing a tax increase for everyone earning $250,000 or more. That is incorrect. Their taxes will rise beginning on January 1 if the fiscal cliff is not averted; the President's proposal therefore does not alter their tax liability, as the law would go into effect the same day that the fiscal cliff (if not replaced by his proposed law) would raise everyone's taxes.
The Republicans are concerned about the deficit, and, being unwilling to reduce it by increasing tax rates even just relative to the low rates adopted early in the Bush Administration (when the deficit was small), want heavy cuts in spending but not in defense spending. The amount of nondefense discretionary spending is small, however, so the Republicans want the cuts to be concentrated in entitlement programs, mainly Social Security, Medicare, and Medicaid. Obama resists these cuts, because the entitlement programs are immensely popular, particularly though not only among Democrats; and though he is willing to make some cuts (mainly by adjusting the formula for raising social security benefits to keep pace with inflation) in exchange for rescinding the Bush tax cuts, he is unwilling to make the kind of cuts the Republicans want. At this writing, so many Republican Congressmen are adamant against any action on the existing (pre-cliff) tax rates that no compromise is possible unless the Speaker of the House is willing to advocate a compromise that will attract enough Democrats and Republicans to create a majority.
It ought to be easy for the Republicans to agree to some variant of the Obama proposal. The tax "increases" would affect only 2 percent of the population, and they are modest increases; the negative effect of such increases on spending and investing would probably be small, and perhaps completely offset by the effect, modest as it would be, of the higher tax revenues in reducing the deficit. And remember that the tax "increases" proposed by Obama are not really increases, but merely reductions in the Bush tax cuts and in the "fiscal cliff" taxes now scheduled to go into effect on January 1. Before Bush's tax cuts there was very little sense that Americans are overtaxed, especially Americans with high incomes.
The conservative Republicans find themselves in a difficult position: they want to reduce the deficit, but they don't want to raise any tax rates. They are open to tax reforms that would generate additional tax revenues, but such reforms, mainly reducing tax deductions, are very difficult to achieve politically because the main deductions—mortgage interest, charity, and state taxes—are extremely popular. The Republicans advocate spending cuts, but draw the line at cutting defense spending, and so cannot achieve substantial deficit reduction without big cuts in entitlement spending, but as I said the principal entitlement programs are very popular—even Medicaid, which supplements social security benefits for many people, and is already underfunded.
During the election campaign, Romney was criticized for wanting to deal with the deficit solely through capping deductions and reducing nondefense spending, without specifying the deductions that would be capped or the size of the caps, and without specifying what major entitlement programs would be cut and if so by how much. He seemed to have taken Medicare off the table. It remains unclear what specific, feasible, and substantial measures the Republicans propose for reducing the deficit.
Realistically, the best we can hope for at the present time is a modest increase in tax revenues along the lines proposed by the President, some modest cuts in discretionary and entitlement spending—tax and spending measures that will reduce the deficit, albeit not dramatically, without interrupting the gradual recovery of the economy from its doldrums—and the prospect that continuing economic recovery will reduce the deficit quite apart from changes in tax revenues or spending.