The frantic negotiations in Washington to avoid the fiscal cliff in January may appear to be mostly a battle over higher taxes on the rich. At the moment, negotiations seem to have hit a temporary impasse. But the strenuous debate between President Obama and House Speaker Boehner over how to stave off the $700 billion or so of automatic spending cuts and tax hikes scheduled for 2013 is obscuring a larger and far more disturbing issue: whichever way the negotiations go, the result will be slow economic growth next year at best, and possibly outright recession.
A fair observer might ask why the US is doing this to itself. Both Obama and Boehner say they want to reduce deficits by roughly $2 trillion over the next 10 years—in this major issue, they are closer together than is commonly realized. The battle centers around whether it should be through tax increases (Obama) or spending cuts (Boehner). But even if the underlying goal were justifiable—and it is based on very cautious estimates of future growth rates—there is no compelling economic argument for beginning this process in 2013. Taking $700 billion of buying power out of the economy in its current state, as the fiscal cliff does, would be a body blow, leading to outright recession and unemployment rates of up to 10 percent or higher. Economic recovery would not be immediate, and unemployment rates could well remain above 8 percent indefinitely even once recovery had begun.
But a compromise that reduces that impact to $300 billion, or even $200 billion, by reinstating many tax cuts and reducing spending cuts, will still rob the economy of a huge amount of buying power at a time when it needs every penny. The result will be tepid growth in 2013, just when the economy seemed to be gathering momentum—and little progress on reducing unemployment.
Politics aside, there are other, far better options. The US Congress could simply delay any and all tax hikes and spending cuts, even those mandated by the Budget Control Act of 2011, until 2014, when odds are the economy will be stronger and unemployment substantially lower. One beneficial exception to such a plan would be to raise taxes on the top 2 percent, as President Obama originally insisted, while postponing all other changes that could undermine the economy in 2013, including the payroll tax cuts and of course the expiration of the Bush tax cuts on the other 98 percent of Americans. Recent economic history shows clearly that raising taxes on the rich does far less to undermine economic growth than cuts in government social programs; we even had a boom under President Clinton after taxes were raised on higher-income Americans.
Of course, delaying the fiscal cliff is a political pipedream.
This is all the more distressing since it is not at all clear that a $2 trillion deficit reduction over ten years is even necessary to stabilize America’s finances. The projections are based on a conservative estimate of potential economic growth by the Congressional Budget Office. Yet even the $2 trillion objective is well below proposals made by others. Erskine Bowles and Alan Simpson, the chairmen of Obama’s budget balancing commission, are seeking, according to their original plan, another $4.6 trillion in spending cuts and tax increases.
If the main goal is simply to stabilize the level of government debt in proportion to GDP, the Simpson-Bowles proposal is way out of line. That $2 trillion goal, according to Richard Kogan, a budget expert at the Center on Budget and Policy Priorities, would maintain the debt-to-GDP ratio at about 73 percent in 2022, easily manageable in his view. That’s the current ratio, though it will rise and then fall in the interim if the $2 trillion goal is met.
Under such a plan, federal budget deficits would average a moderate 2.5 percent to 3 percent a year for the next decade or so. If we return to more rapid growth in productivity—the output per hour of work—growth of incomes will be faster and federal tax revenues higher, meaning significantly less than $2 trillion in future cuts will be necessary.
The better way to reach a $2 trillion savings is through tax hikes on the well-off. The Obama administration proposed something close to such a plan in the early rounds of negotiations, deriving nearly $1.5 trillion in future deficit reductions from tax rate increases on income as well as capital gains and dividends, among other changes aimed mostly at the wealthy. Such increases will hurt economic growth least. But again, such an approach is a political pipedream. Obama has since backed off and is willing to make more social spending cuts. The latest report suggests he will accept a change in the way inflation is computed to determine Social Security benefits, which will amount to a significant reduction in benefits over time.
Rising federal deficits will matter someday: government debt could reach levels that are well above 100 percent of GDP. By the late 2020s, some fifteen years from now, it is clear that deficits will begin to increase very rapidly because of Medicare and Medicaid expenditures. But the main driver of growing expenditures for these programs will be higher health care costs. Obamacare may be a good start towards taming these costs, but health care is where the nation’s focus should be. Health care cost increases have slowed markedly in recent years. If that is the beginning of a long-term trend, we will have less reason to fear a future deficit crisis.
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Any rational prescriptions for restoring long-term economic growth should also include future tax increases once the recovery is under way, but they should not be aimed merely, or even primarily, at reducing the budget deficit. They are also needed to meet serious investment needs, including rebuilding the nation’s collapsing infrastructure, improving access to the Internet, paying for the transition to clean energy, and providing more support for equal education and pre-K programs. Many current social programs are also inadequate and should be expanded rather than cut back. Highest on the list is Medicaid, whose reimbursements rates to physicians are too low to fund adequate basic care for the poor.
Americans remain among the least-taxed citizens in the developed world. There is ample room to raises taxes to serve the nation’s future without undermining growth. Meantime, it is difficult to conjure up much optimism about the current talks between Obama and Boehner. We can only hope they will choose the lesser evil.
