Wonk Post: Understanding the Fiscal Cliff

Warning: this post is very long and very detailed…continue at your own risk.

A recent report by the non-partisan Congressional Budget Office (CBO), entitled “The 2012 Long-Term Budget Outlook,” describes the fiscal forces currently at work.  Specifically, it focuses on the long-term effects of mandatory spending programs (Social Security, Medicare, and Medicaid), the coming “fiscal cliff,” and

the impact they would have on America’s long-term debt.  The report states that, under the current trajectory, total spending on Medicare, Medicaid, and Social Security alone will increase from 10% of GDP to 18% of GDP over the next 25 years.  As a comparison, total government spending (entitlement programs plus discretionary spending plus interest on the debt) has averaged 18.5% of GDP over the last 40 years.

It is well understood in Washington that any type of solution to the long-term fiscal challenges will require reform of entitlement programs, but the political will has been lacking.  In this article, however, I will focus on the more pressing concern: the fiscal cliff, otherwise known as “taxmaggedon.”  The same report by the CBO shows that if currently scheduled spending cuts and tax increases – what they call the Extended Baseline Scenario – are allowed to take place, the debt held by the public as a share of GDP will gradually decrease from 73% in 2012 to 53% in 2037.  Sounds great, right?  On the other hand, if Congress rejects the previously instituted cuts to military spending and extends the so-called Bush Tax Cuts – what they call the Extended Alternative Fiscal Scenario – public debt as a share of GDP will rise to 93% in 2022 and 199% in 2037.  Sounds terrible, right?  As with many things, it’s not so cut and dry.  The scenarios are explained below.

Before we can discuss this analysis, we have to gain a greater understanding of what the coming “taxmaggedon” actually is.  Essentially, it terrifyingly refers to the day of January 1st when the Bush era tax cuts – income tax, capital gains, dividends – expire and the mandatory spending cuts go into effect.  This scenario is compounded by the fact that estimates place the date of the next raising of the debt ceiling sometime between November and January, which is also a lame duck session of Congress.  The amalgamation of various complex factors into one small window, combined with the political leadership of either a recently reelected president to whom Republicans will be hesitant to give a victory or a recently defeated president with little political clout, compounds the fiscal and economic dangers.  Each of the factors, which I will briefly discuss, will need to be dealt with carefully, although (as has become the custom) they will all most likely be wrapped into one omnibus bill.

Bush Tax Cuts:

The period between March 1991 and March 2001 was the longest continuous expansion in U.S. economic history, according to the National Bureau of Economic Research.  But the sunset of this period, with the bursting of the Dot Com bubble and the attacks on 9/11, marked the beginning of a two-year recession.  In response, the Bush Administration passed what they believed to be the solution: tax cuts.  The Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 instituted a broad range of tax reforms.  The top tax rates were reduced by 3%; the lowest rate was reduced by 5%; rates were reduced for capital gains and dividends; the Child Tax Credit was expanded and the “marriage penalty” was all but eliminated; and the Dependent Care Credit was expanded.

The Bush Administration sought to address two inefficiencies in the tax system which they felt were hindering economic growth.  The first is a foundational principle of conservatism: capital is better allocated by families and individuals then by government.  Lower individual income tax rates allow the people to spend their own money as they please and, in doing so, stimulate the economy as consumers; thus the income rate reduction.  The second inefficiency was the double-taxation of dividends, which are earnings distributed by corporations to shareholders.  Prior to the Bush Tax Cuts, dividends for high-income earners were taxed at 35% after the corporate profits had already been taxed at the same rate; thus the double-taxation.  As Bush Treasury Secretary John Snowe explains here, this distortion of the tax code “favors debt financing over equity capital formation, because interest is deducted as a cost of doing business and lowers taxable income, while dividends are taxed twice.”

Congress didn’t eliminate the double taxation, but they substantially reduced it; dividend and capital gains tax rates were reduced to 15%.  It is hard to judge the success of an individual policy over a decade as there are various influencing factors (wars, losses in manufacturing, financial crisis) and the Bush Tax Cuts are no different.  As a Pew report entitled “States of the Union Before and After Bush” explains, real median household income dropped slightly, the unemployment rate increased, and the national debt doubled.  At the same time, Gross Domestic Product (GDP) increased by almost $2 trillion, GDP per capita increased by almost $4,000, and inflation was essentially zero.  While the tax cuts contained a sunset provision so that they would expire in 2010 (this was meant to avoid the Byrd Rule which is another story altogether), they were extended in the 2010 lame duck session for two years.

Mandatory Spending Cuts/Debt Ceiling:

In the spring of 2011, a newly-elected Republican Congress claimed a mandate from the American people to cut spending at any cost.  Twice – in February and April – Congress came within hours of a government shutdown before short-term spending measures (Continuing Resolutions) were passed, cutting spending in each case.

As spring moved to summer, it became clear that a larger fight was brewing, one over the debt limit.  Some freshman Republican members campaigned on a promise not to raise the debt ceiling, which is the legal limit on borrowing by the federal government.  Many economists, in a letter organized by two liberal think-tanks, warned that failure to raise the debt ceiling, essentially risking the “full faith and credit of the United States” for political purposes, would “have a substantial negative impact on economic growth at a time when the economy looks a bit shaky.  In a worst case, it could push the United States back into recession.”

But Republicans were determined to attach significant budget cuts, with no tax increases, to any deal to raise the debt limit.  Various negotiations ensued, including ones led by Vice President Biden, which involved $1-2 trillion in cuts, and President Obama, which involved $4 trillion in cuts.  Both failed after each party’s base revolted against the leaked details of revenue increases and entitlement reform.  On July 31, the deadline instituted by the Treasury Department, Congress and the White House reached a deal which raised the debt ceiling by $2.4 trillion, imposed caps on discretionary spending that, according to the Center on Budget and Policy Priorities, will “reduce their funding by more than $1 trillion,” and mandated another $1.2 trillion in cuts. The cuts, however, were not determined at the time; a bipartisan Congressional commission (“super committee”), which included Republicans and Democrats from the House and the Senate, was created to determine which programs, department, and expenditures were to be cut with a deadline of the last week of November.  Even with this agreement and the prevention of default, S&P, one of the three ratings agencies, downgraded the U.S. credit rating for the first time in American history citing “political brinksmanship.”

If the committee of six Democrats and six Republicans failed to reach a deal (and fail they did), Congress instituted a sequester – mandatory spending cuts, split evenly between Defense spending (a Republican sacred cow) and non-Defense spending, including entitlements (a Democratic sacred cow).  The exact breakdown can be seen here.

When the super committee failed, the sequester was triggered; the $1.2 trillion in mandatory cuts are scheduled to go into effect on January 1, 2012, the same day the Bush Tax Cuts are scheduled to expire and near the estimated date of when the debt ceiling must be raised again.

The Politics:

In his book “Do Not Ask What Good We Do,” Robert Draper recounts a meeting that Republican pollster Frank Luntz had with most of the incoming freshman Republicans in November of 2010.  He asked how many of them would vote to raise the debt ceiling; four raised their hands.  He asked how many would not vote to raise the debt ceiling; the rest exuberantly raised theirs.  Luntz responded, “Good for you, because your base is going to kill you if you vote to raise the debt ceiling.”  It was a reflection of the ideals of the Tea Party movement, a movement that opposed the foibles of government profligacy and Wall Street arrogance alike.  The overt truculence, which created the movement in the first place, got the fight they were looking for, but ultimately failed to prevent the debt ceiling’s increase.

But the Tea Party has remained resilient, and the Republican Party has maintained, even doubled down on, its emphasis on reducing government spending and lowering taxes to spur economic growth.  President Obama proposed extending the Bush Tax Cuts, but only for those earning less than $250,000 a year, and allowing the remaining taxes cuts to expire.  Republicans, meanwhile, counter that raising taxes on anyone during a recession is bad economic policy, particularly since many small businesses making over $250,000 file individual income tax and would thus see their taxes raised.

Further compounding the political picture is the fact that this debate is taking place in the midst of a presidential race.  President Obama and his campaign feel the tax issue is a political winner for them, while Governor Romney’s choice of Paul Ryan as his number two reflects a doubling-down on the small-government, low-tax, individual-freedom philosophy of the House Republicans.  With the debate playing out on the campaign, and most of Congress campaigning for their own reelection, nothing will happen until after November when the results of the election mandate (or lack thereof) will bring some clarity to the opinions of the American people.

The Fiscal Cliff:

The question is now: Which is more important: economic growth or deficit reduction?  The Congressional Budget Office estimates that if the Bush Tax Cuts expire and the mandatory spending cuts go into effect, the result would be to “lower taxable incomes and raise unemployment, generating a reduction in tax revenues and an increase in spending on such items as unemployment insurance.”  Growth for the 2013 fiscal year would be an abysmal 0.5% resulting in a double-dip recession.  The CBO also estimates, however, that allowing current law to be implemented on January 1st would reduce the deficit by $560 billion in 2013 alone, even allowing for lost tax revenue as a result of a recession.

Democrats argue that while raising taxes on the middle class in a recession is bad economics (and bad politics), allowing taxes to go up on high-income earners is both politically and economically palatable.  As President Obama often says in his stump speech, you grow an economy “not from the top down, but from the middle out and from the bottom up.”  Republicans argue that while raising taxes on high-income earners may be a great political talking point, they – in the form of small businesses and those involved in capital formation – are the ones creating the jobs that will allow businesses to hire and the middle class to thrive.  They also argue that maintaining lower tax rates will not only allow business to grow, but also increase tax revenue at the same time, a point first diagrammed by Reagan economic advisor Arthur Laffer on a napkin.

 

What is clear is that if nothing is done between now and January 1, the American economy will see a significant downturn.  As investor Donald Luskin points out, the increased taxes on dividends alone – which would go from 15% to 43.4% – creates the potential for the market to significantly contract.  In simpler terms, Luskin states that “on Jan. 1, an investor won’t keep $8.50 of that dividend—he’ll pay a 43.4% tax and keep only $5.66. Suddenly, a stock that yielded him 8.5% now yields only 5.66%.”  To think this won’t have a significant impact on the market is to be naive.

The fiscal cliff is the result of an amalgamation of various problems that politicians have failed to adequately deal with.  While it presents serious fiscal and economic challenges, it also presents an opportunity for real bipartisan reform to take place, either to stimulate the economy or to address the deficit.  As John F. Kennedy once famously said, “In a crisis, beware of the danger – but recognize the opportunity.”  Whether debt or economic growth is the focus of an agreement, the opportunity that has presented itself should not be squandered.

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About chrishartline

I'm a recent graduate of Houghton College in Western New York, a huge Baltimore sport fan, and an aspiring politico.
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4 Responses to Wonk Post: Understanding the Fiscal Cliff

  1. Pingback: In the News: 8.22.2012 | chrishartline

  2. I found this page by accident, but now want to tell others to make the effort. Good solid stuff. Thanks.

  3. w1llsm1th says:

    One of the – if not the – best explanation of the fiscal cliff, and the current debt crisis. Absolutely flawless. Regarding the quote by JFK you mentioned in the last paragraph.. very true. That’s where true growth can truly formulate, if not hindered by faulty central-banker choices of abusive monetary easing.

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